Factors That Affect the Level of Effective Demand - Dissertation Example

Factors That Affect the Level of Effective Demand Effective Demand Demand of a product in economics refer to the quantity of a product that purchasers are willing and able to buy at different prices in a specific period of time, other things remaining the same. (BAMFORD 2002) In economics, demand of a product can be notional or effective. Notional demand for a product emerges from wanting it and is not backed by the purchasing power. On the other hand, effective demand of a product emerges from wanting it and is backed by the purchasing power of the buyer. Hence it is the effective demand of a product that is of real significance to the economist since the buyer should have both, the willingness and the ability, to buy a product. For example, a person would like to own a Ferrari but does not have money to acquire it. This is notional demand. But if this willingness to buy a Ferrari is backed by the purchasing power, it is effective demand. Factors that affect the level of effective demand: 1) Price of a product: Price is the most significant determinant of effective demand of a product. According to the law of demand, when a price of a good rises the quantity demanded will fall (SLOMAN 1999). Hence there is an indirect relation between effective demand of a product and its price. As shown in the following figure, as the price rises from P1 to P2, the quantity demanded falls from Q1 to Q2. Hence the demand curve is downward sloping as shown below. For example, if price of coffee doubles, its demand will fall. People will switch to tea and other substitutes and the quantity demanded of coffee will fall. 2) Income of people: As the income of people rise, effective demand for most goods will also rise. Such goods are called normal goods (Lipsey and Chrystal 2001). But the demand for some goods falls as the income of people rise. Such goods are called inferior goods such as margarine. Moreover, the distribution of income also affects the level of demand for a product. For instance, if more income went to young people, the demand for clothes, DVDs will increase. 3) The price of substitute and complementary goods: The higher the price of substitutes goods, higher will be the demand for this good since people would switch from high priced substitute good to this good and its effective demand will increase. For example, if the prices of petroleum rise, the demand for natural gas would increase since people will switch from high priced petroleum to natural gas. When the goods are Complementary goods (goods demanded together), the increase in price of one good will decrease the demand for other. For example, an increase in the price of petrol will cause a decline in the demand for petrol (HOBDAY 1999). 4) A change in taste or fashion Effective demand also depends on the change of tastes of the people. Tastes are affected by advertising and observing other people. So the more desirable a product is, more is its effective demand. 5) Expectations of future price changes If it is expected that the price of a product will rise in future, its effective demand will increase since people will but more now before the price goes up. For instance, if it is announced that the price of butter will rise, people are likely to buy more now while current prices last. Price Elasticity of demand: According to the law of demand, quantity demanded of a good falls as its price rises. But the extent to which the demand falls is not obvious. Hence price elasticity of demand is the responsiveness of quantity demanded to a change in price. If the quantity demanded is highly responsive to price, we say the product’s demand is price elastic i.e the rate at which demand rises is greater than the rate at which price falls and if it is less responsive, we say product’s demand is price inelastic i.e rate at which demand rises is less than the rate at which price falls (Samuelson and Nordhaus 2001). Income Elasticity of Demand: Income elasticity of demand refers to the responsiveness of demand to changes in income. If income increases but demand of the product increases by a smaller proportion, then that product is income inelastic. Most of the necessities such as wheat, rice are income inelastic. But if income increases and demand of the product increases by a larger proportion, then that product is income elastic. Most of the luxury goods such as air conditioners are income elastic. If income elasticity of demand of a product is greater than 1, its demand is income elastic and if it is less than 1, the product’s demand is income inelastic. The formula used to measure the price elasticity of demand is as follows: Percentage change in quantity demanded ÷ percentage change in price If price elasticity of demand of a product is greater than 1, its demand is price elastic and if it is less than 1, the product’s demand is price inelastic. A seller of a product can the value of price elasticity of demand of a product to increases his revenue. If the value of price elasticity is less than 1, the seller can increase the price of the product and his revenue will increase since the rate of quantity demanded will fall by less than the rate at which price is increased. On the other hand, if price elasticity of the product is greater than 1, the seller should lower the price of his product and his revenue will increase since the rate of quantity demanded will rise by more than the rate at which price is decreased (Titley and Moynihan 2000). Part 2 Pricing Strategies: A company may adopt different approaches to determine price at which it sells its product or service. The strategy adopted depends on the business objective of the company (Borrington and Stimpson 2006). The price charged may not necessarily depend on the cost of manufacturing of the product. For example, a product may cost $30 but a company may sell it for $100 depending on the brand image of the company and the perception of the people buying the product. Some of the pricing strategies used by firms to determine price are as follows: 1) Cost-plus pricing The firm calculates the number of products it will produce and then determine the total cost of producing this output. A percentage markup is added to determine the final price. For example, if the cost of making 200 toothpastes is $400 and the company wants to make a profit of 30% on each toothpaste. Following calculation will be used by the company to determine price: (Total cost ÷ output) × % Mark up = Selling price $400÷200 + 30% = 2+0.30 =$2.30 is the selling price of each toothpaste Although the method is very easy to apply, company may lose its business if the selling price is set a lot higher than its competitor’s price. 2) Penetration pricing: Penetration pricing strategy is used by a firm that is new and wants to penetrate into the market by setting price lower than its competitors (Brooks and Weatherstone 2000). For example, a new toothpaste company enters the market and offers toothpaste at a lower price than its competitors. If this strategy is successful, consumers will try the new toothpaste due to its lower cost and will become regular customers if they like the new toothpaste. However, the product will be sold at a lower price and hence the sales revenue of the company will be low. 3) Price skimming: When a firm introduces a new development of an old product, it uses the price skimming strategy to set its price. Such product is sold at a price higher than the market price because of the uniqueness of the product. Moreover, the innovation would have cost a lot in research and development; hence the company seeks to recover those high costs by setting a higher price. Moreover, the high price could also be due to the high quality of the product offered by the company. For example, when Sony introduced Play station 2 it was priced higher than other gaming consoles present at that time. The reason being that Play station 2 was a new product and had better graphics than the other gaming consoles. However, some existing customer base of the company might be lost due to the high price. Hence a company should assess the effects of increasing the price before using the price skimming strategy. 4) Competitive Pricing: This strategy is used by firms to become more competitive. The product is priced I accordance with the price of the competitors or just below them to capture the market. For example, a company selling toothpastes should price the toothpastes in line with its competitors otherwise consumers would prefer competitor’s brands. 5) Promotional Pricing: A firm uses promotional pricing when it wants to set a low price or the product for a limited amount of time. For example, a clothing brand offers its old collections and designs on a discount of 40%. People would come in numbers to purchase the low priced clothes and in this way the company will sell its old collection of clothes. Although the company would earn very little profit on the sale of those clothes, but atleast the company will earn some money for clothes that it might not have been able to sell at all. This could also help in giving boost to the business if the sales of the company are falling. 6) Psychological Pricing: Firms using the psychological pricing strategy keep in mind the effect that the price of a product will have upon customers’ perceptions about the product. If the customer perceives the product as a status symbol, the company would charge a very high price for it. For example, Rolex watches are considered as a status symbol and are very highly priced when compared to other watches. Furthermore, psychological pricing may also involve charging a price which is just below a whole number to create an impression that the product is much cheaper. For example, charging a price of $1.99 for toothpaste instead of $2. Sometimes, supermarkets charge a lower price on products that are purchased on a regular basis to give the customers an impression of being given good value for their money. A company might adopt any of the pricing strategy mentioned above, to set the market price of its product, depending on the objectives of the company. Part 3 Factors that determine the interest rates: Interest rate is the price of current consumption in terms of future consumption. The higher is the interest rate, higher will be the savings in the economy since people will prefer to save money and earn interest on it. The lower the interest rate is, higher will be the investments in the economy since investors can borrow money at a lower rate (Abel and Bernanke 2000). This is shown in the saving-investment diagram: As the above figure show, interest rate is 10% if savings equal investments and there is equilibrium. The real interest rate change when there is a shift in either the investment curve or the savings curve. The following are the factors that shift the investment or the saving curve and hence change the interest rate in the economy. 1) Production opportunities The production opportunities present in an economy is an important factor that determines the interest rate. Production opportunities can be evaluated by analyzing the rate of return available within an economy from various investments in productive assets (Brigham 2000). So if the production opportunities are high, investment curve would shift to right and hence there will increase in the interest rate. 2) Saver’s time preferences for current versus future consumption Other things being equal, most of the people prefer current consumption as opposed to saving for future consumption. Interest rate is the opportunity cost of current consumption since the consumers forgo the interest rate they could have earned by saving their money. If the time preference for consumption is high in the economy, people would consume more and save less. Due to this the savings curve will shift to left and the interest rate will increase. 3) Risk Risk is the chance that a financial asset will not earn the return promised. The higher the risk associated, the higher is the interest rate. For example, government bonds are very less risky and thus provide a lower interest rate. 4) Expected future rate of inflation Inflation is the increase in the general price level of the economy. Increase in inflation reduces the buying power of the people and the real value of money falls. When people expect inflation to increase in the future, they demand higher return to nullify the effects of inflation. However, inflation only affects the nominal rate of interest and not the real interest rate since real interest rate is already adjusted for inflation. 5) Government policies The monetary policy pursued by a country also determines the rate of interest. If the government wants to control growth in the economy, it will slow the growth of money supply. Due to this, current consumption will fall and savings will increase and hence the interest rates in the economy will increase. i) Changes in interest rates will have an impact on the housing market and the construction industry. If interest rates increase, people will save more of their money in banks and other interest earning savings. Hence the demand for investing money in real estate will fall. Moreover the increase in interest rates will also increase the cost of mortgage interest rate payments and the demand for purchasing houses will fall. Furthermore, if interest rates increase to the extent that people can not afford to pay their mortgages, the default on mortgages will increase and due to this they will have to sell their houses. Hence an increase in interest rates has an adverse impact on the housing markets as people demand less houses. On the other hand, if interest rates fall, people will invest more and save less. Hence the demand for investment in real estate will increase. Moreover lower interest rates decrease will decrease the cost of mortgage and people would be more willing to buy houses. (Economics.help 2008). The construction industry is usually financed by borrowings. So if the interest rates rise, cost of borrowing will rise and the profits for the construction industry will shrink. Hence, other things remaining the same, an increase in the rate of interest has an adverse impact on the housing market and the construction industry. (Economics.help 2008) ii) Interest rates will also impact the market of foreign holidays from UK. If the interest rates in the economy rise, people will save more money since the opportunity cost of current consumption will be high. People will reduce their current consumption. So generally people would not prefer to go on holidays and spent their money if the interest rates rise. On the other hand, if interest rates fall, people will save less and can afford to spend money on holidays since the opportunity cost of current consumption is low. Hence, other things remaining the same, an increase in the interest rates has an adverse impact on the market of foreign holidays and a decrease in interest rates have a positive impact on the market of foreign holidays. (Economics.help 2008) Part 4 Bank regulations: A bank is a financial institution licensed by a government. Government uses various tools to regulate the commercial banks to protect the rights of the depositors and ensure smooth running of the banks. Bank failures could cause large and uncontrollable fluctuations in the quantity of money in circulation (Mishkin 1997). Banking problems can have a very adverse impact on the overall economy of the country. Banking problems can have a negative effect on the economic growth, Balance of payments and the foreign exchange rates of a country. Furthermore, money laundering and terrorist funding is mostly done through banks and laws are needed to control such illegal activities. Hence it is extremely important for the government to regulate the banks and prevent the problems a country’s economy can face if its banking system falls apart. The central bank is the main regulatory body for the banking sector (Todaro and Smith 2002). Examples of Central Banks are the Federal Reserve System in the United States, the Bank of England and the Bank of Japan. The central bank uses various tools to regulate the commercial banks in line with its monetary policy. Some of the tools used by the Central Bank to regulate the commercial banks are as follows: Minimum capital requirements: Commercial banks need to meet a certain capital requirement before they start their operations. This is to guarantee that the bank is competent enough to pay back its depositors. Special Deposits: The central bank has the power to require institution in the banking sector to place funds into a special account at the central bank. These deposits earn some interest but are non operational as the commercial bank can not lend those deposits. These special deposits can only be released when the central bank wishes to increase the liquid assets held by the banking sector. If the central bank is pursuing a tight monetary policy and wants to lower the money supply in the economy, it increases the special deposits so that commercial banks have limited funds available to lend to the people. However, the central bank has to pay the interest rate on the special deposits which increases the expenses of the government. Quantitative and Qualitative Regulations: The central bank also imposes quantitative and qualitative controls on the commercial banks. They may limit the growth of bank deposits to some specified percentage over a given period of time. These quantitative restrictions are often accompanied by qualitative control. The commercial banks are asked to restrict loans for specific sectors that need boost from the government. For instance, a country may encourage its banking sector to provide a certain percentage of their loans to the agricultural sector. Although this will give boost to the agricultural sector, but non performing loans would also increase if the farmers are not able to pay their loans due to a bad crop. Hence, the banks and the government may suffer if such qualitative restrictions are imposed. Interest rate policy: Interest rates are important instruments of monetary policy used by the central bank. Central bank sometimes imposes interest rates ceiling to reduce competition between the banks and other financial institutions. This helps in lowering the cost of borrowing and hence investment in the economy increases. However, this does not contribute to the financial stability in the long run. Cash reserve requirements: Central Bank regulates the commercial bank to keep a certain percentage of the deposits in cash or in deposit with the Central Bank. It is imposed to enhance the liquidity adequacy of the commercial banks. Imposing cash reserve requirement increases the confidence of the depositor and reduces the threat of bank runs. However, they are largely insufficient to avoid a bank panic and are used mostly by the Central Banks to control the money supply in the economy. Disclosure requirements: The central Bank regulates the commercial banks to disclose their financial statements appropriately and within a specified time. This helps in reducing stock price volatility and excessive speculation. Such regulations are used excessively by the Central Bank. But these regulations have some costs to the economy. Regulations imposed restrict market competition and may protect inefficient private financial banks from competition and may protect their own business interests at the expense of the consumer. Moreover, high cash reserve requirements increase the costs of the banks and hence this excessive cost can lead to disintermediation. So the Central Bank should assess its policies and amend them if necessary. It is important to regulate the banks but the extent to which the banks should be regulated has to be assessed. REFERENCES Bamford, C. et al., 2002. Economics: AS and A Level. Cambridge University Press. Sloman 1999. Sloman, J., 1999. Economics, 3rd ed., Prentice Hall Europe. Lipsey, R. and Chrystal, A., 2001. Economics, 9th ed., Oxford University Press. Hobday, I., 1999. Economics- a first course, 2nd ed., Hodder and Stoughton. Samuelson, P.A. and Nordhaus, W.D., 2001. Economics, 17th ed., McGraw-Hill. Titley, B. and Moynihan, D., 2000. Economics: a complete course, 3rd ed., Oxford University Press. Borrington and Stimpson 2006. Borrington, K. and Stimpson, P., 2006. IGCSE Business Studies, 3rd ed., Hodder Murray. Brooks, I. and Weatherstone, J., 2000. The business environment: challenges and changes, 2nd ed., Financial Times Prentice Hall. Abel, A.B. and Bernanke, B.S., 2000. Macroeconomics, 5th ed., Addison Wesley. Besley and Brigham 2000. Besley, S. and Brigham, E.F., 2000. Essentials of managerial finance, 12th ed., South-Western College. Economics.help. 2008. Effect of Interest rates on Housing and Shares [Online] (Updated 2008) Available at: http://www.economicshelp.org/blog/interest-rates/effect-of-interest-rates-on-housing-and-shares/ [Accessed 6 August 2010]. Economics.help. 2008. UK Construction Industry [Online] (Updated 2008) Available at: http://www.economicshelp.org/blog/economics/uk-construction-industry/ [Accessed 6 August 2010]. Economics.help. 2008. Effects of Rising Interest Rates in UK [Online] (Updated 2008) Available at: http://www.economicshelp.org/macroeconomics/monetary-policy/effect-raising-interest-rates.html [Accessed 7 August 2010]. Mishkin 1997. Mishkin, F.S., 1997. The Economics of Money Banking and Financial Markets, 6th ed., Addison-Wesley. Todaro, M.P. and Smith, S.C., 2002. Economics Development, 8th ed., Addison Wesley. 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