Price Elasticity of Demand for Tobacco, Starbucks Coffee, and Oil

This article explores the price elasticity of demand for tobacco, Starbucks coffee, and oil, and discusses the implications for market behavior and the need for government intervention. It examines the factors influencing the elasticity of demand for each product and the impact of monopoly power in the Australian postal service market.

Running head: ECONOMICS
Economics
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1ECONOMICS
Table of Contents
Question 1..................................................................................................................................2
Price elasticity of demand......................................................................................................2
Question 2..................................................................................................................................6
Monopoly of Australian post.................................................................................................6
Inefficiency of monopoly and need for government intervention.........................................7
References................................................................................................................................10
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Question 1
Price elasticity of demand
In economics, price elasticity of demand is an estimate for measuring relative
responsiveness of quantity demanded of a good for a given change in price of the product.
Demand does not always respond in the same way for a given change in price. For some
goods magnitude of change in demand is larger than the magnitude of change in price. This is
a case of relatively elastic demand and estimated elasticity of demand in this case is greater
than 1. For some goods on the other hand, change in quantity demanded is relatively smaller
than the given change in price (Kreps, 2019) This a case of relatively inelastic demands and
measured price elasticity of demand in this case is less than 1. Whether demand is elastic or
inelastic that depends on behavior of consumers and nature of the good.
Price elasticity of demand= Percentage change∈demand
Percentage change∈ price
The section discusses price elasticity of demand for three different goods in reference
to three different published article.
Tobacco
The first product chosen for discussion is Tobacco. The article published on official
website of cancer council of Australia discusses the price elasticity of demand for Tobacco
products. As stated in the article, price elasticity of demand for tobacco product in most
nations is found to be relatively inelastic in nature. That means measured price elasticity of
demand is less than 1 indicating percentage change in demand for tobacco products are
generally less than corresponding percentage change in price (Bickel et al., 2017). The
demand for Tobacco products are found to be relatively less elastic as compared to other
consumers’ product. Continuous research in this area has suggested that there is only a
moderate decrease in the demand for tobacco products in response to an increase in price
followed by a moderate decrease in both percentage of people who smoke and that of the
number or amount of tobacco consumed by the remaining smokers. Research on high income
countries shows that average price elasticity of demand for tobacco product in -0.4
(tobaccoinaustralia.org.au, 2019). This implies for 10 percent increase in elasticity results in a
decline in tobacco consumption by 4 percent. In case of UK and US, the price elasticity of
demand lies in the smaller range from -0.2 to -0.6.
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Figure 1: Inelastic demand curve for Tobacco
(as created by author)
The demand curve for tobacco products is shown as DD. Because of relatively
inelastic demand, the demand curve is relatively steep. In the above figure, an increase in
price of tobacco products from P0 to P1 reduces demand for concerned product from Q0 to Q1.
As clearly indicated from the figure, the proportionate increase in demand is less than the
proportionate change in price.
There are different factors that influence the behavior of tobacco consumption and
hence, elasticity of demand (Cowell, 2018). The addictive nature of tobacco product makes
the demand inelastic. People are highly addictive to nicotine content and hence, are unable to
reduce demand even for a large increase in price. Price elasticity of demand also varies across
different age group. Young adults and teenagers are relatively more sensitive to a price
change on tobacco products compared to older adults both due to lower earning and smoking
habits (Gibson & Kim, 2019)
Starbucks coffee
The second product chosen for analysis of elasticity is Starbucks coffee. Published
article on demand elasticity of Starbucks discusses circumstances both when Starbucks coffee
seems to be relatively elastic and when coffee demand is relatively inelastic. The analysis us
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important to understand the impact on demand of Starbucks coffee for a recent increase in
price. Starbucks has announced an increase in demand for coffee by 10 to 20 percent
(Schwartz, 2018). The price elasticity of demand for Starbucks coffee is mostly elastic in
nature because of availability of substitutes. When large number of substitutes are available,
people get higher opportunity to switch demand from one product to another. This makes
demand more sensitive to price or price elastic (Jones, 2016). The figure below shows the
relative elastic demand for Starbucks coffee and associated movement in response to price.
Figure 2: Elastic demand curve for Starbucks coffee
(as created by author)
The elastic demand curve for Starbucks coffee is shown as D1D1. The flatter demand
curve indicates demand is highly sensitive to price. The price moves up from P1 to P2,
demand decrease from Q1 to Q2. The proportionate decrease in demand is greater than that of
the proportionate increase in price as indicated from the demand curve.
The main determinant of price elasticity of demand of Starbucks coffee is the number
of available substitutes (McKenzie & Lee, 2016) Starbucks is facing high degree of
competition from McDonald’s and Dunkin. When Starbucks announces to raise price of latte,
the existing competitors like Pan era Bread, Krispy Kreme and Mc Donald’s lower the price
to attract more consumer. This cause a relatively large decrease in demand for Starbucks
coffee. On the other hand, demand of Starbucks is relatively inelastic for consumers believing
McDonalds’s and Dunkin Donuts are not substitutes of Starbucks.
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Oil
Another important product discussed for elasticity estimate is oil. The article
discusses published by Forbes discusses price elasticity of demand oil and its impact on
global economic growth. It is commonly said that, oil demand has a relatively less elasticity.
The main reason inelastic demand for oil is availability of smaller number of direct
substitutes (Clemente, 2017). The elasticity of oil however varies over different time horizon.
Demand is highly inelastic in short run. One study has found the average elasticity of demand
of gasoline in the short run is -0.26. This suggests for every 1 percent increase in price of oil,
demand decreases by 0.26 percent. The estimates on long run elasticity however found that
long run elasticity of demand is -0.58. That is demand decrease by 0.58 percent for 1 percent
increase in price of gasoline (Friedman, 2017). The elasticity though is less relatively
inelastic, however demand of oil responses more in the long run than that in the short run.
The demand curve of oil is relatively steeper as shown in the figure below.
Figure 3: Inelastic demand curve for Oil
(as created by author)
One important determinant of demand elasticity of oil is time. As oil is a necessary
product, in the short run people cannot adjust their demand much. In the long run however
with introduction of alternative products demand becomes relatively more sensitive (Caldara,
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Cavallo & Iacoviello, 2018) The impact of an increased oil price thus is temporary and shows
a sharp upward trend in spending on oil in the short run.
Question 2
Monopoly of Australian post
Monopoly refers to a specific market structure where the entire market is controlled
by a single firm. In such a market, the single seller enjoys significant market power (Baumol
& Blinder, 2015). In Australia, example of a service signifying characteristics of monopoly
market is Postal service. The postal company owns a statutory monopoly power in delivering
letters. The monopoly power is limited to letters weighted less than 250 grams. The
associated cost for delivering letters is lower than $2.40. It is the responsibility of the single
company to deliver letter to different areas of Australia. One distinctive feature of monopoly
market is that entry is completely barred in the market (Chung, 2017). The nature of barrier
that prevents entry of other firms in the postal market legal or regulatory. Australian
government allows monopoly power in the postal service making Australian post a legal
monopoly.
Economic theory explains different factors resulting in a monopoly power of a firm.
There are four most widely discussed factors creating monopoly power. In the presence of
high fixed cost, new entrants are not willing to enter the industry because of their inability to
bear the burden of high cost (Cowen & Tabarrok, 2015) The market can be served efficiently
if there is only a single firm as this firm can enjoy the benefits from the presence of
economies of scale. Single firm enjoys monopoly power in the market because of its
ownership of a specific input. A third source of monopoly power of firms is the network
externality (sunshinecoastdaily.com.au, 2015). Regulatory or legal barriers as imposed by
Australian government also act as a source of monopoly power in the market. For Australian
post, the monopoly power is derived from regulatory or legal barriers. In return, of the
monopoly power, the postal company is supposed to deliver parcels or letters to different
parts of Australia at a relatively cheaper rate. In addition, the firm also needs to make a
mandatory delivery to 90 percent addresses to different areas for at least five times in a week.
Government also specifies minimum number of required outlets covering rural and urban
areas.
Monopoly power of Australian post restricts competition in the postal service market.
The regulatory barriers prevent entry of small companies in the market of delivering letters or
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parcels. The small companies thus do not get the opportunity to expand the business
(Carmody, 2015). Existence of a single firm increases market power largely and the firm is in
a position to charge extremely high price. The price charged by the monopoly postal
company is above the fair market price. Australian post and its associated subsidiaries device
considerable monopoly power in the Australian market. Monopoly power of the single postal
company gives it the power to influence market price. The firm can increase or decrease price
to earn maximum profit. An increase in price causes sufferings for Australians. In recent
time, the company has proposed to increase the rate for postal service to recover the increased
cost burden. Changes have also been initiated to change off-peak rates.
The monopoly power of Australian post has long been given an advantageous position
to the company. Other companies though are restricted to enter the industry; the company is
now facing threat of increasing competition from the system of online delivery. The spread of
internet and online service delivery has significantly lowered the volume of letters and
parcels delivered by the company. If the trend continues, there is possibility of loss for the
company in future. It is not feasible for monopolists to continue the business operation in the
long-run. In order to prevent future loss, the company has now attempted to increase postal
rate for different postal delivery service. For delivery of business mail, the rate has been
proposed to be increased. Attempts have also been taken for an upward revision of charges of
pre-sort service. The company has submitted the proposal to raise postal rate on the ground of
preventing loss in future.
Inefficiency of monopoly and need for government intervention
Economic efficiency is measured in terms of either productive or allocative
efficiency. Firms that operate corresponding to the minimum point of long run average total
cost. Firms attain allocative efficiency by charging price equivalent to the marginal cost of
production. The monopoly market fails to achieve efficiency in the sense of either productive
efficiency or allocative efficiency. Given the huge market power, the firm is always in a
position to charge a price above the marginal cost. This results in allocative inefficiency in
the market. Given the market power, it is also not necessary for the monopolist to expand its
operation up to the minimum point of average total cost (Nechyba, 2016). It is possible for
the firm to continue production at the falling part of average total cost. The operation of
monopolists to the left of minimum average total cost in the long run results in productive
inefficiency.
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The inefficient outcome in monopoly market arises due to the face that monopolist
charges a higher price producing a relatively lower quantity of output. The misallocation of
resources in a monopoly market leads to a welfare loss called deadweight loss to the society.
The inefficiency of monopoly market and resulted deadweight loss can be illustrated by
making a comparative analysis between outcome under perfect competition and that under a
monopoly. This is shown in the following figure.
Figure 1: Monopoly market and deadweight loss
(as created by Author)
In figure 1, efficient price and output combination as achieved under a competitive
market are P* and Q* respectively. In contrast, equilibrium output in a monopoly market is
Q1 (lower than competitive output) and equilibrium price in the monopoly market is P1
(higher than competitive price). The resulted inefficiency in the monopoly market leas to a
deadweight loss as indicated in the figure.
Given the inefficient outcome in a monopoly market, it is necessary for the
government to intervene and restores efficiency in the market. Most of the nation uses
antitrust law to direct the monopoly power. In case of Australia, the Australian Competition
and Consumer Commission evaluates the monopoly power of acting firm and controls their
market power to save consumers from exploitation of monopoly firms. The commission
imposes several regulatory responsibilities in order to examine rationale for increasing postal
rate. ACCC makes it mandatory for the monopoly postal company to use the earned revenue
in giving subsidies to other competitive firms in the business (accc.gov.au., 2019). The
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competitors in postal services often claim the subsidies given by Australian post actually
damages competition. ACCC therefore closely monitors the efficient use of cross subsidy that
Australian Post gives.
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References
accc.gov.au. (2019). ACCC role in postal services. Retrieved from
https://www.accc.gov.au/regulated-infrastructure/postal-services/accc-role-in-postal-
services
Baumol, W. J., & Blinder, A. S. (2015). Microeconomics: Principles and policy. Nelson
Education.
Bickel, W. K., Moody, L. N., Snider, S. E., Mellis, A. M., Stein, J. S., & Quisenberry, A. J.
(2017). The behavioral economics of tobacco products. Behavioral Economics and
Healthy Behaviors: Key Concepts and Current Research, 33.
Caldara, D., Cavallo, M., & Iacoviello, M. (2018). Oil price elasticities and oil price
fluctuations. Journal of Monetary Economics.
Carmody, B. (2015). Australia Post is hurting small businesses with PO Box monopoly, says
delivery company Sendle - SmartCompany. Retrieved from
https://www.smartcompany.com.au/growth/australia-post-hurting-small-businesses-
with-po-box-monopoly-says-delivery-company-sendle/
Chung, F. (2017). Could this be the end for Australia Post?. Retrieved from
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Clemente, J. (2017). Does The Price Of Oil Even Matter?. Retrieved from
https://www.forbes.com/sites/judeclemente/2017/10/14/does-the-price-of-oil-even-
matter/#5b267a0f7e03
Cowell, F. (2018). Microeconomics: principles and analysis. Oxford University Press.
Cowen, T., & Tabarrok, A. (2015). Modern principles of microeconomics. Macmillan
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Friedman, L. S. (2017). The microeconomics of public policy analysis. Princeton University
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Gibson, J., & Kim, B. (2019). The price elasticity of quantity, and of quality, for tobacco
products. Health economics, 28(4), 587-593.
Jones, E. (2016). Consumer Preferences for Coffee: Hot and Wet, or Quality and
Flavor?. Journal of Food Products Marketing, 22(3), 350-380.
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Kreps, D. M. (2019). Microeconomics for managers. Princeton University Press.
McKenzie, R. B., & Lee, D. R. (2016). Microeconomics for MBAs: The economic way of
thinking for managers. Cambridge University Press.
Nechyba, T. (2016). Microeconomics: an intuitive approach with calculus. Nelson
Education.
Schwartz, E. (2018). Why Consumers Might Care About a Starbucks Price Hike. Retrieved
from https://econlife.com/2018/06/prices-at-starbucks/
sunshinecoastdaily.com.au. (2015). Australia Post plays fair despite reserved letter monopoly.
Retrieved from https://www.sunshinecoastdaily.com.au/news/australia-post-plays-
fair-despite-reserved-letter-/2606603/
tobaccoinaustralia.org.au. (2019). 13.1 Price elasticity of demand for tobacco products -
Tobacco In Australia. Retrieved from https://www.tobaccoinaustralia.org.au/chapter-
13-taxation/13-1-price-elasticity-of-demand-for-tobacco-produc
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