MAE101 Economic Principles: Microeconomic of Australian Mining Boom

Q4. Suppose income elasticity of a mid-sized family car in Australia is 1.4. What will be the effect of mining boom on the demand for cars?

Q5. The price of iron ore in 2010 was about US $145 per dry metric ton in the international market compared to about US $110 per dry metric ton in the domestic market in Australia, and Australia exported about US $46 billion worth of Iron Ore that year. Explain Australia’s gains from a welfare perspective. Use an appropriate diagram to explain your answer.

Q6. In 2010, the minimum wage in Australia was A$ 15. What may have been the likely impact of this minimum wage policy in the Australian mining industry? Graphically explain your answer.

Q7. Suppose, during the boom, the Chief Economist at the Australian Bureau of Agricultural and Resources Economics and Sciences (ABARES) was given the task of evaluating the implications of the imposition of a tax on the production of mineral ores in Australia. If the mineral ore market was already operating at a socially optimum level, explain the welfare implication of the proposed tax that should be included in the economist’s recommendations. Use diagram to explain your answer.

Q8. Suppose Australia’s iron ore producers join together to become a single seller. With the aid of a diagram, illustrate and explain the firm’s profit maximising output and pricing decisions in the iron ore market.

Answers:

1.a

Figure 1: Effect of mining boom in mineral ore market

In a market price and quantities are determined by the twin forces of demand and supply. Demand is the desire of people to purchase something based on their purchasing power. Supply on the other hand shows sellers’ willingness to supply at different pricing point (Frank 2014). Figure 1 shows the demand and supply condition in the mineral market. The demand curve is DD and the corresponding supply curve is SS. Equilibrium in the market is defined as a point where the interest of buyers and sellers matches reflected by the intersection of demand and supply curve. DD and SS curve meets at the point E which is the point of initial equilibrium. In the phase of mining boom, both demand and supply increases. Following discovery of several minerals such as Iron, Uranium, Gold and others supply increases. Besides in the beginning of new millennium Australia has started to invent new resources leading to an increase in supply. This is shown with a rightward shift of the supply curve from SS to S₁S₁. Besides supply, there is also an upsurge in demand. The increased demand come from rapidly growing economies like China. This results in an outward shift of the demand curve from DD to D₁D₁. E₁ is the new equilibrium point obtained from the intersection of D₁D₁ and S₁S₁. As a result, the mining ore market expanded with a rise in both price and output. Price in the market increases from P* to P₁ and corresponding quantity raises from Q* to Q₁.

1b.

During mining boom disposable income of the household increases along with the average wage rate. When disposable income increases then there is an upsurge in the housing demand. Most of the goods in household consumption basket have an elastic supply. However, in case of housing the short run supply is relatively fixed as shown in figure 2 (rba.gov.au 2017). Therefore, the mining boom results in a decline in the rates of vacancy and an increase in housing price or rents.

Figure 2: Housing market in the short run

In response to increase in housing prices and rent there might be construction of new houses in the long run. However, because of high interest rate the supply cannot increase to that extent. Hence, there will be relatively small increase in number of houses and there will remain a continuous upward pressure on housing price. This is explained in figure 3.

Figure 3: Housing market in the long run

2.

The theory of comparative advantage suggests that a nation should export goods in which it has a comparative advantage and import goods in which its partner has a relative advantage. The comparative advantage is determined in terms of opportunity cost (Fine 2016). During mining boom new mineral sources are explored. This increases mineral supply in Australia. The technological advancement in the mineral industry reduces opportunity cost of mineral production in Australia. This gives Australia a comparative advantage in mineral production. China on the other hand has lack of mineral resources but can produce electric goods at a lower cost. However, the demand for mineral resources in China are growing. Therefore, it is beneficial for Australia to export minerals to overseas like China and import good in which it has a relatively high opportunity cost like television.

3.

Figure 4: Effect of advancement in firm’s technology

Supply curve depicts a relationship between price and quantity supplied in the market. An increases in price causes an increase in supply while a decrease in price causes an increase in supply. Besides price there are number of other factors affecting supply of a good. The supply of inputs is one primary determinant of supply. What is happening in the factor market likely to affect the supply of final goods (Currie, Peel and Peters 2016). Wheat is the main input in producing bread. A technological advancement of wheat farm increases the wheat supply resulted from a reduced cost. The increased supply of wheat at the given cost increases supply of bread as well. Increase in supply causes a change in supply leading to an outward shift of the supply curve. In the bread market, the supply curve shifts to S₁S₁ from an earlier SS. Increase in supply given the demand pushes down equilibrium price to P₂.

Revenue is the total earnings from selling goods in the market. It is computed as unit price times quantity sold. Therefore, revenue depends on both price and quanity. Change in price and quantity leads to a change in revenue. When price and quantity both increases then revenue increases. However, when price and quantity changes in opposite direction then the effect on revenue become dubious (Baumol and Blinder 2015). It depends on magnitude of price and quanity change. When supply of bread increaes then market price is decreased. Demand of a good is directly related with price. Therefore, a price reduction increases demand. Revenue of the bakery owner depend on the magnitude of price reduction and that of the increase in quanity sold.

If proportioante decrease in price is less than the proportioante increase in quantity then revenue increases and bakery owner is better off. However, when demand is relatively inelastic in nature then change in price is greater than change in quanity sold (Moulin 2014). In such situation bakery owner may not be necessary better off as revenue either remains same or decreases. Such a situation is described in figure 5.

Figure 5: Bread market with inelastic demand

The inelastic demand curve is shown by DD. The price decreases from P₁ to P₂ while the quanity increases from Q₁ to Q₂. It is clearly shown in the figure that (P₁ – P₂) > (Q₂ – Q₁). As a result revenue will decrese.

4.

Elasticity of demand shows the relative responsiveness of demand because of a proportionate change in factors affecting demand. Income elasticity of demand signifies change in demand with respect to change in income. For normal goods a demand changes in lines with income giving a positive income elasticity while for inferior goods demand change in opposite direction of income. Based on the responses of demand elasticities are categorized in different groups (Kolmar 2017). In case where demand changes at a greater proportion than income then elasticity is greater than one. The demand is then called relatively elastic in nature. For luxury goods, demand is relatively elastic. The income elasticity of mid-sized family car is 1.4. This means 1 percent increase in income leads to 1.4% increase in car demand. In times of mining boom in Australia disposable income of the household increases by 13 percent and wage increases by 6 percent. The increase in household income raises car demand more than the income increase. Consequently, both equilibrium price and quantity of car sold in the market will increase (McKenzie and Lee 2016).

5.

Figure 6: Welfare gain from trade

Goods and services that are sold in the international market have a world price. The international price is the uniform price prevailing for the specific goods and services throughout the world. When domestic producers are able to supply the goods or services at price equals to the world price or less than they are able to compete in the world market (Rader 2014). This is only possible for countries having comparative advantage in producing that good or service. In the domestic market price is determined from domestic supply, demand forces. In the mining ore market DD and SS denote the domestic demand and supply curve respectively. Domestic price is set at P* equals US $ 110. If the producers only serve to the domestic buyers, then Q* units are sold. However, there are worldwide demand for iron ore mainly from the emerging economies. The high demand in the international market leads to a high price in the international market. The price of iron ore in the world market is US $ 145. Since, domestic price is less than the world price domestic producers can sell iron ore at the world price and significantly gain from trade. At the world price quantity supplied equals Q₂ while domestic demand equals Q₁. At this price an excess supply of (Q₂ – Q₁) prevails in the domestic market which can be exported. Domestic supply continues to increase unless equilibrium is obtained at the world price. As domestic price is less than that of the world price producers are encouraged to sell in the international market. This will continue until domestic price equals to world price leading to a decline in demand.  The country is benefitted because the loss in consumer surplus from domestic buyers are more than offset by the gain in producer surplus because of the high world price (Friedman 2017). Therefore, total surplus is maximized when producers sell good in the world market and hence, welfare of the nation increases from trade.

6.

Figure 7: Effect of minimum wage in the mining industry

 Minimum wage is set to ensure a minimum payment to the workers. Without intervention the equilibrium wage in the labor market is determined by the labor supply and labor demand condition (Rode 2015). As shown in the above figure W* is the equilibrium wage. At the equilibrium wage L* labor is employed. Now suppose a minimum wage of AUD 15 is set in the mining industry. As the employers now must pay a higher wage, they reduce their labor demand. Demand for labor in the market reduces from L* to L₁. In contrast inspired from a higher wage more laborers now join the market increasing available labor supply from L* to L₂. Therefore, at the minimum wage, supply of labor exceeds the demand for labor. In the mining industry there will be an excess supply of labor of the amount (L₂ – L₁). The excess supply of labor results in unemployment in the industry (Elsner, Heinrich and Schwardt 2014).

7.

Figure 8: Effect of a tax on production in mining industry

A tax is a compulsory payment to the government. A tax on production is an indirect tax and burden of tax is shared by both buyers and sellers (Nicholson and Snyder 2014). The figure above shows the effect of a proposed tax on mining production. DD and SS are the initial demand and supply curve in the mining industry. Before tax the equilibrium is at point E. This is the free market equilibrium obtained from the demand and supply intersection. The price in the market is P* and associated quantity is Q*. The market is at socially optimum level with consumer receives a consumer surplus equals to the area of the triangle EP*B and producers receive a surplus equal to the area of the triangle EP*A. The total surplus is maximized at this point. Now, suppose a per unit tax of t is imposed on production. The tax shifts the supply curve to the left by the amount of tax. The new supply curve is S₁. E₁ is the new equilibrium point obtained from the new supply curve and old demand curve. The producers now have to pay part of their as tax. This discourages production. The price that buyers pay is P_B which is higher than pre-tax equilibrium price. However, the producer receives a price of P_S. The difference between buyers’ price and sellers price is the amount of tax (Cowen and Tabarrok 2015). As the buyers pay a high price because of imposition of tax, the consumer surplus now reduced to the area of the triangle E₁P_BA. The reduced surplus of consumer is not transferred to the producers. After tax, the producer surplus decreases to FP_SB. Now the government received a tax revenue shown by the area of the rectangle E₁P_BP_SF. There is a net welfare loss because of imposition of tax. The dead weight loss to the society is shown by the triangular area EE₁F. The deadweight loss shows the distortion created due to misallocation of resources. Hence, policymakers should impose a tax rate that minimizes the area of the deadweight loss.

8.

When producers in the same industry joined together then it is called horizontal merging. In this situation the sellers instead of competing take joint decision and maximize industry profit. There are different motivations for forming mergers. There are both profit maximizing and non-profit maximizing motive for mergers. The potential gains from merging are realized in the form of economies of scale, rationalization, enhanced knowledge and technology, economies of scope, duplication of effort and purchasing economies (Arrow 2015). The single seller in the market behave like a monopolist and takes decision in a similar way that monopoly does. This is described in the figure below.

Figure 9: Profit maximization of a single seller

The average revenue (AR) curve shows the industry demand curve. The MR and MC curve represent marginal revenue and marginal cost curve respectively. The profit maximization occurs where MR and MC cut each other (Coto-Millán 2013). P* and Q* is the profit maximizing price and output respectively. Profit which equals total revenue less total cost is shown by the shaded region in the figure.

References

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