RVHS H2 ECONS P2 Essay Q1 Soln

1 2017 RVHS Y6 H2 Econs Prelim II Paper 2 Q1 Just a year ago, anticipation of higher profits prompted cattle farmers in the European Union (EU) to switch to produce dairy, which is a m ajor ingredient of many dairy- based products such as cheese. At the same time, EU abolished dairy production quotas while China, a key importer of EU products, saw slower economic growth. The Economist, August 2015 Using economic analysis, discuss the impact these e vents are likely to have had on EU consumers and farmers. [25] Introduction: The demand for dairy arises from dairy-based produc ts manufacturers (e.g. the laughing cow) who manufacture and sell cheese. Hence they buy/consume dairy as it is a factor input to produce cheese. On the other hand, supply comes from cattle farmers who produce dairy for sale. The impact of these events on dairy consu mers and farmers can be measured via changes in the consumer expenditure and total reven ue received by farmers. This will then affect consumer expenditure and total revenue for d airy-based products in a range of markets, such as premium cheese and house brand bread. ❶ Impact of events on EU consumers and farmers of dairy Firstly, in the past year, there is an increase in the number of farmers producing dairy. This is due to the anticipation of higher profits to be made in the dairy market, resulting in some farmers switching from rearing cows for beef to dairy. As such, at every price level, there are more farmers willing and able to supply dairy and the supply of dairy increases. Secondly, the abolishment of dairy production quota s affected the supply of dairy. A dairy quota imposes a physical limit on the quantity of dairy t hat can be produced within EU in a given period of time. It restricts the supply of dairy to keep prices hi gh. The abolition of production quota will lead to an expansion of EU da iry production, leading to significant increases in EU net exports to the world market, hence supply of dairy increases. Taken together, the supply of dairy will rise from S 0 to S 1 as shown in Figure 1 . This will cause the price of dairy to fall, which is accompanied by a rise in its quantity demanded. The extent of this increase in quantity demanded depends on the price elasticity of demand (PED) for dairy as PED measures the degree of responsiveness of quantity demanded to a change in its price, ceteris paribus. Figure 1: Increase in supply Pe Qe Qi Q0 De Price Quantity S0 P0 0 Di Pi A B C S1

2 If the demand for dairy is relatively price inelastic, the fall in price from P 0 to P i will cause the quantity demanded to rise less than proportionately from Q 0 to Q i. This will result in a fall in the consumer expenditure/total revenue from 0P 0AQ 0 to 0P iCQ i. And if the demand for dairy is relatively price elastic, the fall in price from P 0 to P e will cause the quantity demanded to rise more than proportionately from Q 0 to Q e. Thus, the consumer expenditure/total revenue will rise from 0P 0AQ 0 to 0P eBQ e. In this context, it is more likely that the PED val ue of dairy is less than one as it is deemed as a necessi ty for firms (e.g. the laughing cow) that produce cheese as dairy is one of the factor i nputs to produce these foods, i.e. PED<1. As such, EU consumers of dairy generally gai n from lower prices and higher quantity consumed, while EU farmers lose out, assum ing unchanged costs of production. At the same time, China, a key importer of EU dairy , saw slower economic growth. The economic slowdown in China implies that income incr eases at a decreasing rate. An increase in income, albeit at a slower rate has inc reased consumers’ purchasing power. Consumers are now more willing and able to purchase dairy, which is a normal good, i.e. YED>0. Since the demand for dairy is derived from the demand for dairy-based products, demand for dairy increases. As seen in Figure 2, demand for dairy shifts rightw ards from D 0 to D 1. This will cause the price and quantity of dairy to rise. However, the e xtent of the increase in price and quantity will depend on the price elasticity of supply of da iry, ceteris paribus. If the supply of dairy is relatively price inelastic, the increase in price from P 0 to P i will cause the quantity supplied to rise less than proportionately from Q 0 to Q i. This will result in an increase in consumer expenditure/total revenue from 0P 0AQ 0 to 0P iCQ i. On the other hand, if the supply of dairy is relatively price elastic, the increase in price fro m P 0 to P e will cause the quantity supplied to rise more than proportionately from Q 0 to Q e. Thus, the consumer expenditure/total revenue will rise from 0P 0AQ 0 to 0P eBQ e. In other words, in both instances, consumer expenditure/total revenue increases. In this context, it is more likely that the PES val ue of dairy is more than one due to the short gestatio n period as cows typically produce milk for around 9 – 10 months of the year. Hence, EU farmers receive higher total revenue while EU consumers incur higher consumer expenditure on diary. Figure 2: Increase in demand P0 Q0 Price Quantity Si Pe 0 Do Pi A B C Se D1 Qe Qi

3 Combined effect on the market for dairy: Overall, the combined effect on the market for dair y includes a rise in both its demand and supply. This will cause the equilibrium quantity to rise with the change in price being indeterminate as this is dependent on the extent of change in demand and supply . In this context, due to the economic slowdown in China, it is likely that rise in income may not lead to a substantial increase in demand for dairy. Henc e, the increase in supply from S 0 to S 1 is likely to outweigh the increase in demand from D 0 to D 1. With reference to Figure 3, there will be a fall in equilibrium price from P 0 to P 1, and an increase in equilibrium quantity from Q 0 to Q1. Total expenditure/revenue could increase, decrease or remain unchanged depending on how much price and quantity has changed. ❷ Impact of events on EU consumers of dairy-based pr oducts such as premium cheese Turning to the dairy-based products market such as premium cheese, we note that the EU producers of premium cheese are firms such as the l aughing cow, while consumers are those who purchase cheese for consumption. The fall in price of dairy, a factor input for cheese means that cheese producers incur a lower cost to produce cheese. This translates to higher p rofits, ceteris paribus; hence cheese producers are now more willing and able to produce the good, leading to an increase in supply of cheese from S 0 to S 1 as shown in Figure 1 . This will cause the price of premium cheese to fall, which is accompanied by a rise in i ts quantity. The extent of this increase in quantity then depends on the price elasticity of de mand (PED) for premium cheese, ceteris paribus. In this context, it is more likely that the PED val ue of a typical brand of premium cheese is more than one as there are many s ubstitutes available in the market/ not a necessity to consume premium cheese, i.e. PED>1. Since the demand for premium cheese is likely to be relatively price elastic, the fall in price from P 0 to P e will cause the quantity demanded to rise more than proportionately from Q 0 to Q e. Thus, the consumer expenditure/total revenue will r ise from 0P 0AQ 0 to 0P eBQ e, as seen in Figure 1. 0 Q0 Q1 P1 P0 S0 D1 D0 Quantity S1 Figure 3: Combined effect of an increase in demand and increase in supply in the dairy market Price

4 On the other hand, the slowdown in economic growth in China implies that income increases at a decreasing rate. An increase in income, albeit at a slower rate has increased consumers’ purchasing power. Consumers are now more willing an d able to purcha