Tag: income elasticity of demand

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Dreaming of a white Christmas

This autumn has been one of the mildest on record. Whilst this may be very nice for most of us, certain industries have been suffering. For example, gas and electricity consumption is down as people delay turning on their heating. One sector particularly badly hit has been clothing. Sales of winter clothes are substantially down and many retailers are longing for colder weather to boost their sales.

Of course, this is not helped by consumer incomes. With inflation at around 5% and average (pre-tax) weekly earnings currently rising by less than 2%, real incomes are falling. In fact over the year, even nominal disposable incomes are down 2.1%, given the rise in national insurance and income tax. And the problem of falling incomes is compounded by worries over the future state of the economy – whether it will go back into recession, with further falls in real income and rises in unemployment.

It’s no wonder that retailers are longing for some cold weather and for their customers to return from the seaside or their garden barbecues to the shopping malls. Look out for the ‘sales’ signs: they’re beginning to spring up as desperate retailers seek to attract wary customers.

Webcast
Retailers slash prices in Christmas build-up BBC News, Tim Muffett (25/11/11)

Articles
Winter woes: warm weather means shoppers aren’t buying as much Guardian, Zoe Wood (21/11/11)
Shoppers urged to be savvy as Christmas sales last for weeks The Telegraph, Victoria Ward (21/11/11)

Data
Earnings tables: Labour Market Statistics ONS (November 2011)
Personal Income and Wealth ONS
Price Indices and Inflation ONS
Personal Inflation Calculator (PIC) ONS

Questions

  1. Identify the determinants of demand for winter clothing.
  2. How responsive is demand likely to be to these determinants (a) over a period of a few weeks; (b) over a period of a few months?
  3. What factors should a retailer take into account when deciding whether to make pre-Christmas discounts?
  4. Assume that you are employed but are afraid of losing your job in a few months’ time. How would this affect your consumption of (a) seasonal goods; (b) durable goods; (c) day-to-day goods?
  5. What longer-term strategies could retailers adopt if they predict tough trading conditions over the next two or three years?
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Don’t Thomas Cook it?

With pressure on household incomes, many have had to forego spending on luxuries and travel is seen by many as just that – a luxury they can no longer afford. Add on to this some unexpected external shocks and it’s unsurprising to see a company such as Thomas Cook, the second largest holiday business in the world, in talks with banks. It provides some 19 million holidays per year, but has seen a relatively rapid deterioration in its finances.

Its debts total in September 2011 was some £900 million and the value of the company has declined significantly in recent times. However, the most notable decline has been since it emerged that Thomas Cook was in talks with its banks in preparation for tougher times to come. It is hoping to receive £100 million from a range of banks including HSBC and Lloyds, but on this news Thomas Cook share prices fell by some 75%. However, Thomas Cook has said that the company is simply requesting money as a cushion and that it is not in a desperate financial situation. As the Acting Chief Executive, Sam Weihagen said, ‘I think investors should have confidence in Thomas Cook’.

Many factors have contributed towards Thomas Cook’s current situation – volcanic ash clouds, political unrest and unkind weather, but also some internal strategic decisions, such as their continued focus on package holidays, despite the fact that data suggests 2 in 3 people that go to Spain (a popular package destination) are actually not on a typical package holiday. The key thing with travel is that it is very much based on confidence (as we have also seen with the banking sector). If confidence in a company declines, people stop booking holidays with them and so further financial issues are created. This issue is even more significant when a well known brand name, such as Thomas Cook is the company in trouble. Nothing else makes such great headlines as a well known brand in trouble. So, should holiday makers be concerned? The following articles consider the situation that Thomas Cook faces.

Thomas Cook makes it hard to see the funny side Telegraph, Alistair Osborne (22/11/11)
Thomas Cook dives on bank talks BBC News (22/11/11)
How Thomas Cook shares dive 75% on new of bank talks BBC News (22/11/11)
Thomas Cook reassures holiday makers after shares plunge Guardian, Simon Bowers and Patrick Collinson (22/11/11)
Thomas Cook risks customer exodus during bank talks after stock plunges Bloomberg, Armorel Kenna and David Altaner (23/11/11)
Fears for Thomas Cook after shares sink 75% Independent, James Thompson (23/11/11)
Thomas Cook shares crash after default warning Reuters, Matt Scuffham (22/11/11)

Questions

  1. Explain the reason why share prices have fallen for Thomas Cook. Use a diagram showing the demand and supply of shares to support your explanation.
  2. Distinguish between the internal and external factors that have contributed to Thomas Cook’s current position.
  3. Under which aspect of PEST and STEEPLE analysis would you place the above influences?
  4. In the Telegraph article, an industry source says: ‘In a business like this you need a very conservative capital structure because you don’t know what’s going to come and bite you.’ What is meant by ‘a very conservative capital structure’?
  5. What action can Thomas Cook take to try to improve its current financial position? Think about both costs and revenues.
  6. What type of good would you class a holiday as? Based on this, what sort of figure would you place on the income elasticity of demand for holidays?
  7. How likely do you think it is that other travel companies are also experiencing similar financial issues to Thomas Cook?
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Is the demand for petrol becoming more elastic?

The price of petrol at the pumps has risen substantially over the past few years. In the UK, according to the AA, the average price between January and June 2011 was 133.13p. In the same period in 2010 it was 116.68p; and in the same period in 2008 it was 109.00p.

Over the first six months of 2011, the amount of petrol sold fell by 5.2 per cent. This was on top of the decline in consumption over the previous four years. Between 2006 and 2010 consumption of petrol fell by 17.4%. The consumption of petrol and diesel are given in the following table.

UK consumption of petrol and diesel (tonnes millions)

2006 2007 2008 2009 2010
Petrol 18.14 17.59 16.68 15.76 14.99
Diesel 20.15 21.07 20.61 20.06 20.87
Total 38.29 38.66 37.29 35.82 35.86

Source: Digest of United Kingdom energy statistics (DUKES) (Department of Energy and Climate Change)

So what has caused this decline in petrol sales? Are there multiple factors at work here? Have a look at the articles and consider the explanations.

Articles
Cash-strapped drivers cut petrol use by 15 per cent Channel 4 News (5/10/11)
Sales of petrol slump as skint motorists cut costs Daily Record, Jamie Grierson (5/10/11)
Petrol Sales Plunge As Cash Squeeze Tightens Sky News (6/10/11)
Fuel cost rise ‘forcing change in driver habits’ TRL News, Mary Treen (6/10/11)

Data
Digest of United Kingdom energy statistics (DUKES) Department of Energy and Climate Change
Fuel price report (monthly) Automobile Association
Brent Crude spot prices Energy Information Association

Questions

  1. What factors have caused a fall in consumption of petrol?
  2. If you choose to spend a set amount on petrol, what is your price elasticity of demand?
  3. What determines the price elasticity of demand for petrol?
  4. Why has the consumption of diesel fallen less than that of petrol?
  5. Under what circumstances would an increase in tax on road fuel of 3p per litre (as planned for January 2012), result in a decrease in tax revenue? Why would the price elasticity of demand for road fuel have to be significantly greater than 1 (ignoring the minus sign) and not merely above 1 for this to be the case?
  6. Why is it likely that people’s price elasticity of demand for road fuel will become less elastic the more they have cut back on consumption?
  7. Why is the demand for petrol likely to be more elastic with respect to (a) price, and (b) income over the longer term?
  8. To what extent is the demand for road fuel a ‘derived demand’?
  9. To what extent is the fall in the consumption of petrol a reflection of a movement along the demand curve for petrol or a shift in the demand curve? Explain.
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Riding the commodities Big Dipper

Anyone investing in commodities over the past few weeks will have been in for a bumpy ride. During the first part of 2011, commodity prices have soared (see A perfect storm brewing?). This has fuelled inflation and has caused the Bank of England to revise upwards its forecast for inflation (see Busy doing nothing see also Prospects for Inflation).

But then in the first week of May, commodity prices plumetted. On the 5 May, oil prices fell by 7.9% – their largest daily amount since January 2009. Between 28 April and 6 May silver prices fell from $48.35 per ounce to just over $33.60 per ounce – a fall of over 30%. And it was the same with many other commodities – metals, minerals, agricultural raw materials and foodstuffs.

Many financial institutions, companies and individuals speculate in commodities, hoping to make money buy buying at a low price and selling at a high price. When successful, speculators can make large percentage gains in a short period of time. But they can also lose by getting their predictions wrong. In uncertain times, speculation can be destabilising, exaggerating price rises and falls as speculators ‘jump on the bandwagon’, seeing price changes as signifying a trend. In more stable times, speculation can even out price changes as speculators buy when prices are temporarily low and sell when they are temporarily high.

Times are uncertain at present. Confidence fluctuates over the strength of the world recovery. On days of good economic news, demand for commodities rises as people believe that a growing world economy will drive up the demand for commodities and hence their prices. On days of bad economic news, the price of commodities can fall. The point is that when undertainty is great, commodity prices can fluctuates wildly.

Articles
Commodities plunge: Blip or turning point? BBC News, Laurence Knight (6/5/11)
Commodity hedge fund loses $400m in oil slide Financial Times, Sam Jones (8/5/11)
Commodities: ‘epic rout’ or the new normal? BBC News blogs: Stephanomics, Stephanie Flanders (6/5/11)
Commodities Still a Bubble – But Prices May Continue to Rise Seeking Alpha, ChartProphet (9/5/11)
When a sell-off is good news The Economist, Buttonwood (6/5/11)
Gilt-edged argument The Economist, Buttonwood (28/4/11)
Commodities: What volatility means for your portfolio Reuters blogs: Prism Money (9/5/11)
Gold, silver rise again on debt, inflation concerns Reuters, Frank Tang (10/5/11)
Commodities After The Crash, No Way But Up The Market Oracle, Andrew McKillop (9/5/11)
Outlook 2011:Three Dominant Factors Will Impact Precious Metals in 2011 GoldSeek (9/5/11)
Energy bills set to rise sharply next winter, Centrica warn Guardian, Graeme Wearden (9/5/11)
Dollar triggered commodities ‘flash crash’, not Bin Laden The Telegraph, Garry White, and Rowena Mason (9/5/11)
The outlook for commodity prices Live Mint@The Wall Steet Journal, Manas Chakravarty (11/5/11)
Three ways to play the next commodities bubble Market Watch, Keith Fitz-Gerald (11/5/11)

Data
Commodity Prices Index Mundi
Commodities Financial Times
Commodities BBC Market Data

Questions

  1. Why did commodity prices fall so dramatically in early May, only to rise again rapidly afterwards?
  2. Why do commodity prices fluctuate more than house prices?
  3. What is the relevance of price elasticity of demand and supply in explaining the volatility of commodity prices?
  4. Under what circumstances is speculation likely to be (a) stabilising; (b) destabilising?
  5. To what extent are rising commodity prices (a) the cause of and (b) the effect of world inflation?
  6. If commodity prices go on rising every year, will inflation go on rising? Explain.
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A perfect storm brewing?

Are we heading for ‘perfect storm’ in commodity production and prices? Certainly the prices of many commodities have soared in recent months. These include the prices of foodstuffs such as dairy products, cooking oils and cereals, crude oil, cotton, metals and many other raw materials. The overall world commodity price index has risen by 28% in the past 12 months. The following are some examples of specific commodities:

Price rises in the 12 months to February 2011

• Wheat 62%
• Maize 59%
• Coffee 70%
• Beef 39%
• Sugar 46%
• Palm kernal oil 142%
• Soybean oil 50%
• All food price index 32%
• Crude oil 20%
• Cotton 132%
• Fine wool 55%
• Softwood timber 25%
• Iron ore 78%
• Copper 29%
• Tin 55%
• All metals index 58%
• Rubber 79%.

The problems are both short term and long term, and on both the demand and supply sides; and the effects will be at micro, macro and global levels. Some hard choices lie ahead.

The following webcast, articles and reports explore both the current position and look into the future to ask whether rising commodity prices are likely to continue or even accelerate.

The first link is to a BBC World Debate which considers the following issues: “Is scarcity of natural resources a serious challenge for developing and advanced economies? How great is the risk that scarcity might lead to conflict, both within and between nations? Might a scramble for resources lead to a retreat from globalisation and to greater protectionism?”

Webcast
World Debate: Resources BBC World Debate, Louise Arbour, President and CEO, International Crisis Group; James Cameron, Global Agenda Council on Climate Change; He Yafei, Ambassador and Permanent Representative of China to the UN; Malini Mehra, Founder and CEO, Centre for Social Markets; Kevin Rudd, Minister of Foreign Affairs, Australia (19/1/11)

Articles
Global Food Prices Continue to Rise Reuters, Steve Savage (7/3/11)
The 2011 oil shock The Economist (3/3/11)
Global Food Prices Will Probably Be Sustained at Record This Year, UN Says Bloomberg, Supunnabul Suwannaki (9/3/11)
Food prices to stay high as oil costs, weather weigh livemint.com, Apornrath Phoonphongphiphat (9/3/11)
‘Perfect storm’ threatens agriculture in developing nations Manila Bulletin, Lilybeth G. Ison (9/3/11)
IMF sees no immediate respite from high food prices Commodity Online (7/3/11)
Drought, supply, speculation drive world food prices to record high NZ Catholic (8/3/11)
The Factors Affecting Global Food Prices Seeking Alpha, David Hunkar (7/3/11)
World food prices climb to record as UN sounds alarm on further shortages FnBnews (India), Rudy Ruitenberg (9/3/11)
Food crisis: It’s a moral issue for all of us New Straits Times (Malaysia), Rueben Dudley (8/3/11)
Oil prices: Green light from the black stuff Guardian (5/3/11)
Cotton hits $2 a pound Guardian, Terry Macalister (17/2/11)
Supermarkets are raising prices faster than inflation, says UBS The Telegraph, Philip Aldrick (1/3/11)
What next for commodity prices? BBC News, Jamie Robertson (5/5/11)

Reports
FAO Cereal Supply and Demand BriefFood & Agriculture Organization, United Nations (March 2011)
Rising Prices on the Menu Finance & Development (IMF), Thomas Helbling and Shaun Roache (March 2011)

Data
Commodity prices Index Mundi
Commodities Financial Times, market data

Questions

  1. Identify the various factors that are causing rises in commodity prices. In each case state whether they are supply-side or demand-side factors.
  2. How can the price elasticity of demand and supply, the income elasticity of demand and the cross-price elasticity of demand be used to analyse the magnitude of the price rises?
  3. To what extent are rising food prices the result of (a) short-term (i.e. reversible) factors; (b) long-term trends?
  4. Why are food prices in the shops rising faster in the UK than in many other countries?
  5. To what extent is the future of food security and prices and moral issues?
  6. Why may current oil price rises become an opportunity for the future?
  7. What might be the respective roles be of government, business and consumers in responding to natural resource constraints?