ECON1008 Principles of Economics-Policy of Price Ceiling

a.Based on the determinants of price elasticity of demand, is demand for olive oil price elastic or inelastic Explain your answer. 
b. Based on your answer in Qs 3, explain the impact of a price rise on total revenue of olive oil producers.

But olive oil lovers in Australia are unlikely to get away unscathed either”. Suggest 2 methods on how Australian government can assist to make sure olive oil lovers do not suffer too much from the situation. Make sure you clearly explain the advantages and disadvantages of the methods you have suggested. 

1. Demand elasticity actually captures the consumers’ ability to adjust demand at different pricing point. There is direct impact of price change on quantity demand as suggested from the law of demand. It is generally computed as a percentage change in demand with to a percentage change in price (Mankiw 2014). The extent to which demand changes in line with price is not same in every situation and for every commodity. When change in demand outpace that of the change is price, then elasticity measure is greater than one. In case of inelastic demand elasticity measure is less than one as here responsiveness of demand is less. For luxury items, a small change in demand induces consumers to change their demand largely. Hence, luxury items constitute elastic demand. Olive oil is considered as a luxury product as it is mostly used in restaurant or rich household in the nation. Therefore, the demand for olive oil is price elastic.
2. In case of elastic demand, a small change in price leads to a much greater change in quantity demand. Revenue is the product of price and quantity. An increase in price is likely to increase revenue to the producers. Whereas decrease in demand in response to rise in price, pushes revenue down. The revenue will move to the direction of dominating force (Varian 2014). With an elastic demand of olive oil, decrease in demand more than offset the price rise. Hence, producers in olive oil industry suffer from a loss of total revenue.

With a worldwide shortage of supply in olive production, the price of olive oil is sky reaching. However, Australian people are likely to remain unaffected and they are continuing consumption of olive oil. In this situation, government in Australia should take appropriate policy to support the consumption of olive oil lovers.

                                                                         Market with price ceiling

  In the above figure equilibrium price and quantity with free market condition is indicated as p* and Q*.  Pc is the price when government put a ceiling price in the market.

However, the policy of price ceiling has some shortcomings. With a lower price, an excess demand is created in the market. From supply shortage, a black market can be developed to fulfill the excess demand. There can be inefficiency in production results in deadweight loss to the society.

Another policy that government can adapt is to give a subsidy to olive producers. The subsidy will reduce the effective cost to the producers and then they will be able to maintain their profit margin though offering the good at a low price (Friedman 2017).

However, since the subsidy amount is paid out of government tax revenue consumers though have to pay a lower price for the final product but it can indirectly harm them by increasing tax burden.

References

Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.

Varian, H.R., 2014. Intermediate Microeconomics: A Modern Approach: Ninth International Student Edition. WW Norton & Company.

Parkin, M. and Bade, R., 2015. Introduction to Microeconomics.

Friedman, L.S., 2017. The microeconomics of public policy analysis. Princeton University Press.