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1. Most brands of cars are available in different models. A large rise in the cost of car manufacture and a rise in incomes are likely to affect the sales of various models of cars in different ways.

(a) Explain how elasticities of demand can assist in understanding the effect of each of these changes on the sales volume of different models of car. [10]

Introduction

1. Define PED & YED

2. Sub-division of different models of cars

1. Basic bread-and-butter cars e.g. Toyota Corolla

2. Luxury cars e.g. Mercedes Benz S-class series / Ferraris

Price elasticity of demand

1. An increase in the cost of car manufacture will result in an increase in cost of production for cars → fall in supply → increase in price

2. Demand for bread and butter cars are likely to be relatively more price inelastic since they take up a smaller proportion of the income compared to luxury cars while demand for luxury cars are likely to be more price elastic since they are likely to take up a large proportion of a person’s income

3. While an increase in price will lead to a fall in quantity demanded for both luxury and bread and butter cars - an increase in price will likely result in a more than proportionate decrease in quantity demanded for luxury cars as demand is more price elastic

4. Sales volume for both luxury cars and bread and butter cars will decrease but sales volume for luxury cars will decrease more

Income elasticity of demand

1. An increase in incomes will lead to an increase in demand for both luxury and bread and butter cars

2. Given that bread and butter cars may be considered to be necessities and are income inelastic → the increase in demand would likely be less than proportionate causing a slight increase in sales volume

3. Given that luxury cars are considered to be luxury goods and are income elastic → the increase in demand will likely be more than proportionate causing a significant increase in sales volume

4. We can also consider a 3rd category of cars - cheaper low-end cars (e.g. Tata Nano) which can be considered to be inferior goods. In this case when incomes increase, demand will fall causing a fall in sales volume

(b) Compare and contrast the likely combined impact of both these changes on the revenue earned from the sales of different models of cars. [15]

Combined impact on basic bread & butter cars

1. An increase in incomes will lead to an increase in demand (reflected by a rightward shift in demand from DD0 to DD1) for basic bread and butter cars, but given that demand is likely income inelastic, then increase in demand will likely be less than proportionate resulting in a slight increase in total revenue

2. An increase in cost of production will decrease supply for bread and butter cars (reflected by a leftward shift in supply from SS0 to SS1) → price increases resulting in a less than proportionate decrease in quantity demanded → total revenue increases

3. Given that the impact of both changes independently result in an increase in revenue, the likely combined impact of both changes will likely result an increase in total revenue

4. The increase in revenue is illustrated in Figure 1 from P0Q0 to P1Q1

Combined impact on luxury cars

1. An increase in incomes will lead to an increase in demand (reflected by a rightward shift in demand from DD0 to DD1) for luxury cars, but given that demand is likely income elastic, then increase in demand will likely be more than proportionate resulting in a significant increase in total revenue

2. An increase in cost of production will decrease supply for luxury cars (reflected by a leftward shift in supply from SS0 to SS1) → price increases resulting in a more than proportionate decrease in quantity demanded → total revenue decreases

3. To determine whether the combined impact will result in an increase or decrease in sales revenue, we need to determine the extent of shifts caused by both events

4. Given that luxury cars are a luxury good, the extent of the increase in demand caused by an increase in incomes will likely be greater than the extent of the fall in supply caused by increase in cost of car manufacture.

5. Thus, there will likely still be an increase in sales revenue for luxury cars

6. The increase in revenue is illustrated in Figure 2 from P0Q0 to P1Q1

Combined impact on low-end cars

1. An increase in incomes will lead to an decrease in demand (reflected by a leftward shift in demand from DD0 to DD1) for low-end cars, given that low-end cars are likely to be an inferior good → fall in sales revenue

2. An increase in cost of production will decrease supply for low end cars cars (reflected by a leftward shift in supply from SS0 to SS1) → fall in sales revenue

3. Thus, the combined impact on low-end cars →  will likely still be an decrease in sales revenue for low-end cars

The decrease in revenue is illustrated in Figure 3 from P0Q0 to P1Q1

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