Answers may include:

Definitions

• Price Elasticity of Demand (PED): A measure of the responsiveness of quantity demanded when there is a price change.
• Elastic Demand: Demand is elastic if PED > 1, meaning consumers are highly responsive to price changes.
• Inelastic Demand: Demand is inelastic if PED < 1, meaning consumers are less responsive to price changes.

Diagram

• A demand curve showing both elastic and inelastic sections.
• The elastic region shows that a decrease in price leads to a proportionally larger increase in quantity demanded, increasing total revenue.
• The inelastic region shows that a decrease in price leads to a proportionally smaller increase in quantity demanded, decreasing total revenue.
• The midpoint (unitary elasticity, PED = 1) is where total revenue is maximized.

Explanation

• If demand is inelastic (PED < 1), increasing price leads to a smaller percentage decrease in quantity demanded, increasing total revenue. If demand is elastic (PED > 1), increasing price leads to a larger percentage decrease in quantity demanded, reducing total revenue.

• A firm should lower prices if demand is elastic to increase total revenue and raise prices if demand is inelastic. The diagram illustrates this by showing changes in total revenue in different regions of the demand curve.

• Firms selling necessities (e.g., basic food items) face inelastic demand, whereas firms selling luxuries (e.g., designer clothing) face elastic demand.

• A firm in a competitive market with many substitutes (e.g., soft drinks) will face more elastic demand, limiting its ability to raise prices. A monopolist with fewer substitutes (e.g., patented medicine) can increase prices without a significant drop in quantity demanded.

• In the short run, demand for many products is inelastic, but in the long run, consumers find alternatives, making demand more elastic.

• If production costs are high, increasing prices may be necessary for profitability, but only if demand remains inelastic.

• If demand is elastic, short-term price reductions (e.g., discounts) can significantly boost sales and revenue.

• A firm may charge different prices based on PED in different markets, such as peak vs. off-peak pricing (e.g., airlines, hotels).

• If a government imposes indirect taxes, firms with inelastic demand can pass more of the tax burden onto consumers, whereas firms with elastic demand may need to absorb some of the tax to maintain sales.

Answers may include:

Definitions

• Subsidy: Monetary help (direct or indirect payment) offered by the government to firms (sometimes households) to aid in lowering costs of production.

Economic Theory

• A subsidy reduces production costs, shifting the supply curve rightward from S to S-sub, as observed in the diagram below.
• This establishes a new equilibrium, where the price paid by consumers (Pc) is lower than the original market price (Pe).
• Producers, on the other hand, receive Pc + the subsidy amount, receiving a higher price Pp compared to the original Pe.
• There is also an increase in quantity supplied and consumed, from Qe to Qsub.
• Hence, the government expenditure equals the subsidy amount per unit multiplied by Qsub.

Diagram

• The diagram shows how the subsidy lowers consumer price and increases quantity.
• Highlights the cost to the government and welfare effects on consumers and producers.

Evaluation

• In 2022, the US government provided $12 billion in subsidies to farmers to stabilize food prices.

• Corn prices decreased by 15%, benefiting consumers, but the policy also led to overproduction, environmental concerns, and large fiscal costs.

• Consumers benefit from lower prices but may experience diminishing gains if firms do not pass on the full subsidy.

• Producers gain higher revenues, but inefficient firms may remain in the market due to artificial price support.

• The government faces a budget deficit risk if large subsidies are sustained over time.

• In the short run, prices fall, benefiting consumers and stimulating production.

• In the long run, firms may become dependent on subsidies, leading to misallocation of resources.

• A Subsidy makes essential goods more affordable.

• It supports domestic industries and employment.

• It encourages investment in targeted sectors.

• A Subsidy, however, can be expensive for governments, leading to possible tax increases.

• It can distort market efficiency, leading to overproduction and environmental degradation.

• There is a risk of market failure if subsidies are misallocated.

• The effectiveness of subsidies depends on the elasticity of demand and supply.

• If subsidies target essential goods (e.g., food, energy), they are more justified than for non-essential goods (e.g., luxury items).

• A time-limited subsidy or means-tested approach (targeting low-income consumers) may reduce negative effects.

Conclusion

• Subsidies effectively lower prices for consumers but can lead to market distortions and fiscal burdens.
• The effectiveness depends on the elasticity of demand and the sector receiving support.
• Policymakers must balance economic efficiency with social welfare objectives to optimize the impact of subsidies.