Economics Assignment: Government interventions through price ceilings
Answer 1) The Essential Services Commission of South Australia has raised electricity prices by 18 percent. The carbon tax levied on electricity generation & distribution companies and the feed-in tariff has raised the cost of providing per unit of electricity. The producers & distributors have decided to pass almost all of this cost increase to consumers in the form of higher prices. The Essential Services Commission of South Australia has accepted this recommendation of the electricity and gas producers.
The price elasticity of demand of consumers with respect to electricity is low, that is why the electricity generation companies were able to pass on the entire rise in input costs to consumers. Price elasticity of demand is the percentage change in quantity demanded for a 1% increase or decrease in price, other things remaining constant. If for a 1 % increase in price, quantity demanded decreases by more than 1% then the demand is said to be elastic. If for a 1% increase in price, the quantity demanded decreases exactly by 1 % then demand is said to be uni-elastic. If for a 1 % increase in price, the quantity demanded decreases by less than 1% then demand is inelastic (Samuelson & Nordhaus, 2000).
For essential services like electricity, demand is inelastic. So if the price of electricity rises by 18 %, as in this case, the fall in demand for electricity will be less than 18 %. Therefore even after the decline in demand due to increase in price, the total revenue of electricity producers are likely to increase because of the price rise.
D2
P2 P1
D1
In the above graph, after prices of electricity go up because of 18 % rise in price (represented by the upper line P2) demand for electricity comes down from D1 (intersection of price line and demand curve) to D2. The demand curve D1D2 is steep because demand is inelastic.
Answer 2) D1 S2
S1 D2
Demand and supply curves of electricity & gas sector in South Australia
The demand curve (D1D2) of consumers of electricity in South Australia is a steep one because of the inelastic demand. Supply curve on the other hand is relatively elastic; electricity producers can readily respond to changes in prices by changing supply. The point of intersection of the demand curve and supply curve is the point of equilibrium; demand of electricity is equal to supply at this point. The demand of electricity & gas is inelastic because electricity is an essential service. With increase in prices, consumers try to cut down on their consumption by reducing wastage and using more efficient electrical appliances. Still they cannot completely stop using electricity. In today’s world electricity is the most important resource. Life in its present form cannot be imagined without electricity.
The price of elasticity of demand is determined by various factors. If the goods or service is a necessity then its demand will be inelastic. Electricity is one such necessity. Availability of substitutes is another factor that has an influence on demand elasticity. If the goods or service have readily available substitutes then the demand will be highly elastic. Electricity has no substitute and therefore its demand is highly inelastic. The time that consumers get to respond to price changes also influences the elasticity of demand (Samuelson & Nordhaus, 2000). In the short run demand for electricity is highly inelastic. In the medium and long run consumers switch to more efficient appliances thereby cutting down on their demand for electricity.
P2 D2
P1 D1
O A B
In the above curve P1D1 is the price line before the price rise. P2D2 is the price line after the 18 % price increase. The total revenue of electricity distributors before the price increase is given by the rectangle OBD1P1. The total revenue of electricity distributors after the price rise is given by the rectangle OAP2D2. We can clearly see that total revenues of electricity distributors will increase after the price rise because demand is inelastic.
Answer 3) If the government introduces a price ceiling on electricity price, then it means that the price of electricity cannot be increased above the ceiling. Price ceiling through government intervention may distort the market supply and demand structure in the electricity market of South Australia. The graph below clearly illustrates that.
D1 S2
P2 C
S’ D’
P1
S1
D2
O S’’ D’’
Now in the above figure P2 is the equilibrium price at which supply is equal to demand of electricity. The government intervenes and sets the price ceiling at P1. At ceiling price P1, consumer demand is OD’’ while supply is OS’’. The ceiling may therefore result in a shortage in electricity given by OD’’ – OS’’.
Government interventions through price ceilings often result in shortage. The market mechanism would have automatically adjusted the demand and supply, thereby eliminating any shortage or oversupply (Robert, 2006). If the government intervention in the electricity market of South Australia sets a price ceiling which is above the market clearing price then that would have resulted in oversupply in the electricity market. The only advantage of price ceilings is that they may make electricity more affordable for the poorest consumers, who are at the bottom-of-the-income pyramid, like self-funded retirees. A better strategy would have been to cash transfer the subsidies to the consumers to compensate them for the price rise instead of setting a price ceiling.
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