Question

The leaders of an industry went to see the President to com plain about falling revenues in recent years. Among the data supporting their case, industry A's leaders presented the President with demand elasticity figures, indicating an industry average of \(0.3\). Not wanting to waste his time on what he thought was a trivial problem, the President re commended subsidization of the industry. Why would the President's plan backfire?

Short answer

The President's plan to subsidize Industry A may backfire because the industry's demand elasticity is 0.3, indicating inelastic demand. Inelastic demand means that consumers are not significantly responsive to changes in price. As a result, subsidizing the industry and lowering prices might not lead to a substantial increase in consumption, and thus, the intended improvement in revenues may not materialize. Consequently, the funds used for subsidization could be wasted or inefficiently allocated.

Step-by-step solution

Demand elasticity measures the responsiveness of consumers to a change in the price of a good or service. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. A demand elasticity value greater than 1 means that the quantity demanded is relatively responsive to price changes (elastic), and a value between 0-1 indicates that the quantity demanded is less responsive to price changes (inelastic). In this case, the demand elasticity for Industry A is given as 0.3. #Step 2: Determine the implications of the demand elasticity value#

Since the demand elasticity for Industry A is 0.3, which is between 0-1, it means that the demand for the products or services provided by this industry is relatively inelastic. This implies that consumers' purchasing behavior in this industry would not change significantly when prices fluctuate. In other words, even if prices were to decrease, consumers may not increase their consumption by a substantial amount. #Step 3: Analyze the impact of subsidization on the industry#

Subsidization refers to the financial support provided by the government to help an industry, with the intention of making its goods or services more affordable for consumers. When an industry receives a subsidy, the suppliers can decrease the price of their products or services since the government is covering part of the costs. The intention of subsidization is to boost demand, encourage consumption, and ultimately, improve revenues. #Step 4: Explain why the President's plan may backfire#

Given that the demand elasticity of Industry A is 0.3 (inelastic), a subsidy plan from the President may backfire for this industry. Due to the inelastic nature of demand, even if the suppliers receive financial support and lower their product prices, consumers might not significantly increase their consumption. This means that the industry's revenue may not improve as intended, and the funds used for subsidization could be wasted or inefficiently used. In conclusion, the President's recommendation of subsidization for Industry A based on its demand elasticity value might be counterproductive due to the inelastic nature of the industry's demand. It is essential to thoroughly analyze the implications of subsidizing industries with inelastic demand to avoid undesired outcomes and ensure efficient allocation of resources.

Key concepts

Price Elasticity of Demand

Understanding the price elasticity of demand is crucial to comprehending how changes in price affect the quantity of a product that consumers are willing or able to purchase. Essentially, it reflects how sensitive consumers are to price changes. The formula for calculating this elasticity is: \( \frac{\text{Percentage Change in Quantity Demanded}}{\text{Percentage Change in Price}} \). When the value is less than 1, the demand is considered inelastic, meaning consumers are not very responsive to price changes. Conversely, if the value is greater than 1, demand is elastic, and consumers are likely to change their buying habits significantly with price fluctuations.

For a business, knowing the elasticity helps in setting prices strategically. For inelastic demand, raising prices might lead to an increase in revenue since consumers are less likely to decrease their purchases. However, for products with elastic demand, increasing prices may not be as beneficial since consumers could significantly reduce their consumption or switch to alternatives.

Subsidization Impact on Demand

When a government subsidizes an industry, it provides financial support to decrease the cost of production or the final price to consumers. The rationale behind subsidization is that by lowering the cost for consumers, the demand for the product or service should theoretically increase, leading to greater consumption and potentially higher industry revenues.

However, the effectiveness of this approach heavily depends on the product's demand elasticity. If the demand is elastic, a decrease in price can significantly boost demand. On the other hand, when demand is inelastic, as with Industry A in our example, consumers will not substantially increase their purchasing even if the prices go down, leading to a smaller impact than expected on the industry's overall sales and revenue.

Economic Subsidization Analysis

Economic subsidization analysis involves evaluating the potential impacts of government subsidies on an industry. When analyzing if subsidization is a suitable economic tool, factors like the type of industry, the competitiveness of the market, the price elasticity of demand, and the goals of the subsidization (such as supporting innovation, ensuring accessibility, or preserving jobs) are considered.

In cases where demand is inelastic, like with Industry A, an economic subsidization analysis would reveal that other strategies might be more suitable for supporting the industry rather than direct financial aid aimed at lowering prices. These could include investing in innovation, improving product quality, or focusing on export markets to expand the customer base. An effective analysis helps avoid the misuse of government funds and ensures that subsidies are used where they can truly make a difference.

Inelastic Demand

Inelastic demand signifies a scenario where the quantity demanded by consumers changes very little in response to price changes. This typically occurs for essential goods or services, where consumers do not have many substitutes or for products that constitute a small portion of their overall budget. Products such as medication, basic food items, and utility services often exhibit inelastic demand.

For Industry A, with a demand elasticity value of 0.3, we're seeing an inelastic demand curve. This means that even significant price reductions may not lead to a proportional increase in quantity demanded. Understanding this concept helps businesses and policymakers alike to make informed decisions on pricing, production, and the implementation of any government interventions like subsidies, to ensure that their actions are effective and align with economic realities.