Question

The following scenarios describe the price elasticity of supply and demand for a particular good. In which scenario will a subsidy increase consumption the most? Choose only one. [LO 6.5] a. Elastic demand, inelastic supply. b. Inelastic demand, inelastic supply. c. Elastic demand, elastic supply. d. Inelastic demand, elastic supply.

Short answer

Scenario c (Elastic demand, elastic supply) will increase consumption the most.

Step-by-step solution

Understand Price Elasticity

Price elasticity measures how the quantity demanded or supplied of a good responds to changes in its price. Elastic demand means quantity demanded changes significantly with price changes, while inelastic demand means it doesn't. Elastic supply means quantity supplied changes significantly with price changes, while inelastic supply means it doesn't.

Analyze the Scenarios

Go through each scenario to understand the implications of elasticities. Elastic demand and supply mean changes in price cause significant changes in quantity demanded and supplied. Contrarily, inelastic demand and supply mean changes in price cause minor changes in quantity demanded and supplied.

Determine Impact of Subsidy

A subsidy generally reduces the cost to consumers and/or producers, aiming to increase consumption. When demand and supply are both elastic, a subsidy will cause a larger increase in quantity because both consumers and producers are more responsive to price changes.

Evaluate Each Scenario

a. Elastic demand, inelastic supply: demand is responsive, supply isn't. A subsidy will increase consumption but limited by supply. b. Inelastic demand, inelastic supply: neither side is responsive. A subsidy will have minimal effect. c. Elastic demand, elastic supply: both are responsive. A subsidy will maximize consumption increase. d. Inelastic demand, elastic supply: demand isn't responsive, supply is. A subsidy will have effect limited by demand.

Choose the Most Effective Scenario

Since scenario c has both elastic demand and elastic supply, it allows the maximum increase in consumption when a subsidy is introduced.

Key concepts

Elastic Demand

In the world of economics, understanding demand elasticity is crucial for predicting consumer behavior. When we talk about elastic demand, it means that consumers' purchase quantities change significantly with a slight change in price. This could be due to numerous reasons such as the availability of substitutes or the nature of the good being a luxury rather than a necessity.

Consider a situation where the price of a brand of cereal drops. With elastic demand, you'll see consumers flocking to buy more of this cereal, perhaps even switching from other brands. Elastic demand indicates a strong reaction to price changes, making it a key factor for businesses to consider during pricing decisions.

**Characteristics of Elastic Demand:**

• High sensitivity to price changes
• Presence of substitutes
• Often luxury items or non-essential goods

Inelastic Supply

Inelastic supply is another pivotal concept in economics, denoting a situation where the quantity produced doesn't significantly change with fluctuations in price. This often happens because of production limitations or time constraints.

Imagine a farmer growing apples. If the price of apples goes up, the farmer can't quickly produce more apples immediately due to the growing season. This is a classic case of inelastic supply.

**Key Features of Inelastic Supply:**

• Limited by time or production capabilities
• Often seen in short-term scenarios
• Resources cannot be easily adjusted to meet price fluctuations

Subsidy Impact

Subsidies are financial assistance provided by the government to encourage the consumption or production of certain goods. The impact of subsidies can vary greatly depending on the elasticity of demand and supply for the good in question.

When both demand and supply are elastic, subsidies can significantly increase consumption. Consumers respond positively to lower prices, and producers are motivated to supply more as they receive more earnings. However, if either demand or supply is inelastic, the impact of a subsidy is muted.

**Effects of Subsidies based on Elasticity:**

• Elastic demand and supply: Large increases in consumption
• Inelastic demand or supply: Smaller changes
• Targeted to make essential goods cheaper or stimulate industry growth

Supply and Demand Analysis

Supply and demand analysis is a fundamental concept in economics that helps us understand market dynamics. It involves examining how various factors influence both the quantity consumers want to buy and the quantity producers are willing to sell.

A basic supply and demand analysis considers the equilibrium point, where supply equals demand. If demand is elastic and supply is elastic, a subsidy can shift this equilibrium significantly, increasing the quantity bought and sold. This scenario occurs because both consumers and producers are highly responsive to price changes.

**Components of Supply and Demand Analysis:**

• Equilibrium: The ideal point where demand equals supply
• Factors affecting shifts: Consumer preferences, costs, regulations
• Role of elasticity: Determines sensitivity to changes in market conditions