Effects of Price Changes in Customers

Effects of Price Changes in Customers Demand and supply are two very basic and important terms in economics to study and determine the market equilibrium. A market is the process of buyers and sellers exchanging goods and services. Buyers, as a group, determine the demand side of the market, whether it is consumers purchasing goods or firms purchasing inputs. On the other hand, sellers, as a group, determine the supply side of the market, whether it is firms selling their goods or resource owners selling their inputs. It is the interaction of buyers and sellers that determines market prices and output through the forces of supply and demand. Demand simply means the ability and willingness of consumer to buy certain amount of goods and services at a particular price. According to the law of demand, the quantity of a good or service demanded varies inversely with its price, other things equal. A demand curve is a downward sloping curve and it shows negative or inverse relationship between price and quantity demanded. When the price increases, the quantity demanded by consumer decreases, conversely, when the price decreases, the quantity demanded by consumer increases. A change in quantity demanded is a movement along the demand curve, when price increases, point A moves to point B, and point A moves to point C when there is a price drops as figure 1 shown. Movement along the curve occurs only when there is a price change. There are several reasons why the relationship between price and quantity demanded is negative or inverse. Observed behavior tells us that consumers will buy more goods and services at lower prices than higher prices, ceteris paribus. Diminishing marginal utility is also one of the reasons, it means in a given time period, a buyer will receive less satisfaction from each successive unit consumed, therefore, consumers will only buy added units if the price were reduced. Whereas, a change in demand is a shift of the demand curve, demand curve shift rightward when demand increases and shift leftward when there is a drop in demand. A shift on the curve is caused by the other factors than the price of the good such as government regulations and technology change. When there is a price change, there will be two effects on consumers. First, the substitution effect is an effect caused by a rise in price that induces a consumer (whose income has remained the same) to buy more of a relatively lower-priced good and less of a higher-priced one. For instance, when the price of coffee increases, there are many close substitute goods as options to replace coffee, and consumer can replace coffee by tea with the same amount of income that they are holding and the same price of tea. In this case, it brings a result that the quantity demanded for coffee decreases and the demand for tea increases. Generally, the consumption of goods and services is vastly related to the income available to consumers. Income effect suggests that at a lower price, one can afford more of the good without giving up any alternative goods. In other words, a drop in price will increase the purchasing power of an individual, thus, they are able to buy more of the product than before. For instance, initially, the price of a product is RM200 per unit, and the constant income of an individual is RM1200, this individual is able to purchase 6 units. However, when the price of the product increases to RM220 per unit, he or she can only purchase 5 units. Apart from that, the other important term is supply. Supply means the ability and willingness of producer to produce and supply certain amount of goods and services at a particular price. A supply curve is an upward sloping curve and it shows a positive or direct relationship between price and quantity supplied. When price increases, the quantity supplied increases as well, vice versa, the quantity supplied drops when there is a decrease in price. Changes in prices of a good lead to changes in quantity supplied, which are shown as movement along the supply curve in figure 2 from point A to point B to point C. Changes in supply occur for other reasons than changes in the price of the product itself. For instance, natural disaster, expected future price and many more. A change in any other factor can affect supplier behavior results in a shift of the entire supply curve. A leftward shift is a decrease in supply, and a rightward shift is an increase in supply. Market equilibrium is a situation where quantity demanded equals to quantity supplied at a particular price. The market equilibrium is found at the point E at which the market supply and market demand curve intersect as shown in figure 3. The price at the intersection of the market demand curve and market supply curve is called the equilibrium price, P* and the quantity at the intersection of the market demand curve and the market supply curve is called the equilibrium quantity Q*. A shortage exists at when the quantity demanded exceeds the quantity supplied, whereas, a surplus exists at when the quantity supplied exceeds the quantity demanded. For example, when the market equilibrium price is at RM10 and it increased to RM15, then there will be a surplus of 20 units in figure 4. The quantity demanded dropped to 10 units. Hence, the solution is to decrease the price to market equilibrium price, RM10, to achieve market equilibrium. In figure 5, there is a shortage of 20 units. Suppose the market equilibrium price is also RM10 and the price is decreased to RM5, the quantity demanded increased to 30 units. Thus, it brings a result that quantity demanded exceed quantity supplied which means shortage. To resolve this problem, the price has to be increased to the market equilibrium price, RM10. There are various types of government policies to change the market equilibrium. In an open-market, government intervenes to control the market prices to make improvements on the development and economy of the country as well as social well-fare in view of a conflict that consumer always wants lower prices and supplier wants higher prices. Besides, government intervention in the market also with aims to correct the market failure and minimize the income inequality. The motivations for price controls vary with the market under considerations. Government sets a price ceiling for goods deemed important to low-income households such as flour. A price ceiling is a legal maximum on the price at which a good can be sold. Conversely, a price floor is a legal minimum on the price at which a good can be sold, it is often set by government for wages, since wages are the main source of income for households. When government imposes a price ceiling on a product, there are two possibilities, either a binding or a non-binding price ceiling. However, for a price ceiling to be effective it should be a binding price ceiling and the price ceiling must be set below equilibrium. A price ceiling set above the equilibrium is a non-binding price ceiling, and the price will go back to the equilibrium price eventually by the demand and supply forces. In Malaysia, during the festive season, The Ministry of Domestic Trade, Co-Operatives and Consumerism will impose price ceilings on the essential goods for various festivals. In a recent year, 2013, the Controlled Price Goods Scheme have imposed price ceilings for 20 essential goods including standard chicken, super chicken, local beef, imported beef and so on. For instance, as figure 6 shown, the market price of chicken per kg was initially RM8.50 and the government fixed the price ceiling at RM7.70 per kg which is 70sen lower than the market price. This price ceiling was in force for 17 days only, from 26th July to 11th August 2013 for the festival, Hari Raya Aidilfitri (Themalaysianinsider.com, 2013). The objective of setting the maximum price for the essential goods is to avoid the sellers raising the prices of the essential goods for Hari Raya Aidilfitri. When a price ceiling is imposed, the quantity demanded will exceed the quantity supplied, and a shortage will occur (Thesundaily.my, 2013). Price ceiling is often applied on rent controls, the objective of controlling the prices of rent is usually to counteract the inequality of bargaining power between landlords and tenant, as part of a minimum set of rights to make the market fair. It is very well-known that there has always been housing shortage in New York City, therefore, to avoid rent hikes caused by housing shortage, New York State legislators defend the War Emergency Tenant Protection Act to protect the tenants from rent hikes. For instance, the equilibrium rent is $1000 per unit per month, and the government imposes a price ceiling below the equilibrium rent at $800 per unit per month as shown in figure 7, thus, the price of rent cannot go any higher when it hits the price ceiling and the maximum price of rent will be $800 per unit per month. Rent ceiling is imposed to protect the low-income households in the short run but the long run impact is to avoid abandon of property out of the reason that the investors a re not willing to purchase or construct new housing with low rents, because it is unprofitable to the investors. Beside the benefit of low rent for tenants, there is also a bad impact on tenants. When the rents are low, the landlords tend to provide improper maintenances, poor repairs and painting in order to minimize the cost of renting to make more profit (Block, 2008). As it was mentioned before, price floor is the same as price ceiling but the opposite, it is a legal minimum on the price at which a good can be sold. The best example would be wages as it is the primary resource of most households’ incomes. For example, the New York government has fixed a minimum wage at $8.75 which is above the equilibrium wage ($8.00) in 2014 as figure 8 shown, the wages cannot go any lower than $8.75 as it hits the price floor. This price floor is effective and is called binding price floor. Therefore, the minimum wage is now fixed at $8.75, and the market wage is equals to the price floor (Labor.ny.gov, 2013). Thus, for a price floor to be effective, it must be fixed above the equilibrium wage which is called a binding price floor, a price floor that is set below equilibrium is a non-binding price floor. When a price floor is imposed, there will be a surplus of low-skilled workers, because it would produce willing workers who will be unable to find jobs, an increase in the minimum wage would create additional unemployment for low-skilled workers. The unemployment impact of the minimum wage falls vastly on the least experienced, least skilled persons, often teenage labour, holding the lowest paying jobs. In the most recent case, the Malaysian government has increased the price floor for the acquisition of property for foreign buyers from RM500000 (2010) to RM1million in Federal Territories of Kuala Lumpur, Putrajaya and Labuan, according to a circular issued by Economic Planning Unit (EPU) of the Prime Minister’s Department on 1st March (Thestar.com.my, 2014). The main reason for this implementation is aim to control the ownerships of properties by foreign interests. Refer to figure 9. Beside imposing price floor and price ceiling, the government also intervenes to change market equilibrium through taxes and subsidies. There are two forms of taxes, direct and indirect tax. Direct tax is a fee levied by government on income, whereas, indirect tax is a fee levied by government on the price of goods and services, and indirect tax is the tax that able to make changes on market equilibrium. The objective of collecting taxes is to finance government expenditure, and the government uses the collected taxes for public infrastructure such as streetlamp and so on. Another reason is to discourage of production and consumption. The changes in demand and supply curve vary from the tax levied on sellers or buyers. When government levies taxes on buyers, the consumers tend to buy less. On the other hand, when tax is levied on suppliers, the cost of production will be increased and the suppliers tend to produce less. Just like many other countries do, Malaysian government is imposing Goods and Services Tax (GST) organized by Royal Malaysia Customs Department starting on 1st April 2015 in response to the fiscal deficit that Malaysia is experiencing. GST is an indirect tax based on consumption that applied on all goods and services and it is set at 6%. GST is imposed to provide more revenues to government besides income tax, it is also said to offer a more comprehensive, efficient, transparent and effective tax system (Khoo et al, 2013). As shown in figure 9, when GST is imposed, the supply of goods and services will decrease from SS to SS1 and causes prices rise from P to P1, and the equilibrium quantity will decrease from Q to Q1, thus, the new equilibrium is at E1. Apart from GST, imported motor vehicle tax in Malaysia is very high and it can be taxed up to 100 percent or even more. According to Malaysian Automotive Association (MAA), the excised duty imposed on vehicle ranges from 65 percent to 105 percent on top of the 10 percent sales tax. A Japan-made 2013 Toyota Prius, the price after tax is around RM140000 but a similarly equipped Prius sells for only around RM80,000 in the US and Japan (Hans, 2013). The objective is to reduce the loss of Ringgit Malaysia outflow to foreign country and protect local vehicle manufacturing industry. The local vehicle manufacturers, Proton and Perodua are heavily supported by the Malaysian government through the National Automotive Policy (NAP) (Lee, 2013). This is the reason why the price of vehicle in Malaysia is very expensive as shown in figure 10. Lastly, subsidy can also change the market equilibrium and it may be regarded as a negative tax. Subsidy is a benefit given by the government to groups or individuals usually in the form of a cash payment or tax reduction. The subsidy is usually given to remove some type of burden and is often considered to be in the interest of the public. A subsidy might be given to assist the poor, to help producer and to encourage consumption of goods and services. The Malaysia government has been subsidizing cooking oil since 1992, and more than RM1billion will be given out to stabilize the price of cooking oil every year. Without subsidy, the price of cooking oil was RM3.50 per kg, and the subsidized price is RM2.50. Refer to figure 11, when the cooking oil is subsidized, the supply will shift rightward which is an increase in supply from SS to SS1, then the price of cooking oil drops and the quantity increases from Q to Q1. The government provides subsidy for cooking oil is targeted for household consumers, unfortunately, 30 to 35 percent of subsidized cooking oil are flow to the restaurant operators, hawkers and small-scale food-based industry, it is also said that even 10 percent of them has flowed to foreign countries (Adnan, 2012). On 2nd October 2014, there was a decrease of 20sen on fuel subsidy and the price has increased from RM2.10 per liter to RM2.30 per liter. As shown in figure 12, the supply for fuel decreases from SS to SS1 and the quantity decreases from Q to Q1. The Prime Minister of Malaysia, Datuk Seri Najib Razak who is also the finance minister stated that the reduction in fuel subsidy is due to the reduced revenue for national expenditure. The fuel subsidy was also reduced for other assistance such as education aid and many more (Ahmad and Singh, 2014). Reference List Adnan, H. (2012).  Archives | The Star Online.. [online] Thestar.com.my. Available at: http://www.thestar.com.my/story/?file=/2012/10/2/business/12110226 [Accessed 25 Nov. 2014]. Ahmad, S. and Singh, N. (2014).Najib talks about further subsidy cuts. [online] Free Malaysia Today. Available at: http://www.freemalaysiatoday.com/category/nation/2013/10/22/najib-talks-about-further-subsidy-cuts/ [Accessed 25 Nov. 2014]. Block, W. (2008).Rent Control: The Concise Encyclopedia of Economics | Library of Economics and Liberty. [online] Econlib.org. 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