Question 1.1 Market boundary and market structure of Aldi
The German based company Aldi is currently operating in Australian supermarket industry which is highly concentrated and fiercely competitive. The fast growth of Aldi since 2001 in Australia has a considerable effect on supermarket industry of Australia. The German based competitors Aldi has faced intense competition from two existing giants Woolworths and Coles. The discount operator Aldi largely influences shopping trend of Australian. The private label products have become increasingly popular among Australians. The strong growth of Aldi has increased concentration within the industry in the last five years. Aldi currently holds 8.9 percent market share in Australia (retailworldmagazine.com.au 2018). However, given the current tendency of Australians to switch to online grocery shopping, the company needs to reaffirm its own value credentials.
Question 1.2 Critical evaluation of claims of the article and elasticity
“The conventional wisdom that grocery spending is largely immune from the economic cycle – because it falls into the basket of necessity rather than discretionary spending – has been thrown into doubt”;
Price elasticity of demand refers to an economic measure representing a change in quantity demanded following a certain percentage change in price. analysis of price elasticity of demand is important to evaluate changes in revenue due to a change in price and associated demand. Income elasticity of demand measure changes in demand following a change in income (Frank and Cartwright 2013). Income elasticity helps to determine effect on demand during fluctuation in income. Different phases of business cycle or economic cycle are associated with a change in income and corresponding change in demand. Now nature of income elasticity depends on the type of product. For necessary items, demand is generally assumed to be income inelastic in nature, that is percentage change in demand is always less than the corresponding percentage change in income. For luxury items, demand is income elastic meaning small change in income can bring a large change in demand (Moulin 2014). Demand for groceries that were generally fall in the category of necessary items were previously assumed to be income inelastic. As demand adjusts by a relatively smaller magnitude for a given change in income demand and hence revenue fluctuates relatively less with business cycle fluctuation. As it falls in the category of necessity rather than discretionary spending, expenditure on groceries immune from changes in economic cycle. The traditional believe however now has been highly contested. With increase in cheaper alternative people now are showing tendency to switch their spending to these alternative. With changes in life style people now have focused on cut back their spending on groceries to finance other living costs (Baumol and Blinder 2015). The Deloitte report has found that in response to an increase in living expense one in three Australians cut back their spending on groceries by either buying fewer groceries or switching to private level brands. Nearly 12 percent of Australians now prefer to buy fewer groceries to finance additional living cost. These evidences suggest that spending on groceries are no longer immune from business cycle due to change in life style and preferences.
“Entertainment subscription services is another area that is moving from luxury to essential”;
Income elasticity of demand depends on nature of a good that is whether the good is a necessary or a luxury. As people cannot adjust their demand for necessities even when income changes, demand is relatively income inelastic (Cowell 2018). In case of luxury or discretionary spending, demand changes significantly with change in income. Earlier smartphones or entertainment services were come under discretionary spending of people. People then preferred to watch shows on television. Introduction of different online entertainment services now have attracted a large pool of customers. People now are spending more and more to subscribe entertainment packages. Subscription to Netflix or Spotify now has become an important part of household budget. People even ready to cut down their spending on car, holidays, clothing or even groceries to finance subscription of entertainment services. As documented in the Deloitte report, when people in Australia asked regarding way to finance the extra living cost only 4 percent prefer to curtail their subscription services as against 12 percent to lower luxury or discretionary spending and 12 percent to buy fewer groceries. This shows popularity of entertainment services among people (McKenzie and Lee 2016). As people ready to cut back their spending on other essential of luxury items to pay for entertainment service, this can now be considered as an essential instead of luxury.
“The most resilient services were child care/education and housing…”
The most resilient services were child care/education and housing meaning that these services face relatively lower elasticity of demand. These are services where people tend to cut back their spending the least. Given a busy life schedule people couples in Australia tend to increase their demand for child care service (Friedman 2017). As people cannot sacrifice their jobs to take care of children of their own the demand for child care remains more or less stable. Another necessary service is education. Because of a better future people tend to increase demand for education services. People therefore tend to adjust their demand for education less when income changes. Spending on housing is another important part of household expenditure (Cowen and Tabarrok 2015). With the expectation of increase in housing price people tend to adjust their demand of housing less with change in income. All these indicate that demand for these services are relatively income inelastic in nature.
Question 2.1: Impact of drought on market outcome
Production of agricultural output depends on climatic condition. Production of specific crops require certain amount of water, sunlight, air and other. Lack of any one of the essential components can hamper agricultural production largely. Drought, defined as a situation with of a prolonged dry condition disrupts agricultural production and lowers supply (Nicholson and Snyder 2014). The effect of drought on market of an agricultural product is explained below
Suppose market demand curve of the agricultural product is DD. The corresponding market supply curve is given by SS. Equilibrium in the market corresponds to the point E. This is the point where market demand and market supply curve intersects. The respective equilibrium price and quantity of the product are P1 and Q1 respectively. Now consumer and producer surplus in the marker refers to the respective gain to consumers and producers in the market (Blad and Keiding 2014). Consumer surplus is described as the enclosed area above the equilibrium price and below the market demand curve. Following the above figure, consumer surplus under free market equilibrium is given by the composite area of A+B+C+D. Similarly, producer surplus is the enclosed area above the supply curve and below equilibrium. In the above figure, producer surplus is given by the area F+G+H. Now, outbreak of a drought alters market outcome by affecting the market supply. The lack of water and unfavorable soil condition during drought lowers agricultural productivity (Nechyba 2016). As supply contracts, the supply curve shifts inward to S1S1. Consequently, equilibrium shifts up along the demand curve to E1. The contraction of supply due to drought lowers equilibrium quantity to Q2. Given the demand, the supply shortage increases equilibrium price to P2. The change in equilibrium condition leads to a change in consumer and producer surplus. The increased price lower consumer surplus only to the area of the triangle A. Producer surplus on the other hand lower to only to area B+F. Part of the consumer surplus specifically “B”, is now enjoyed by producers because of high price (Mahanty 2014). Drought thus reduces market quantity while raise market prices. Total surplus reduces because of a decline in both consumer and producer surplus.
Government gives subsidy to farmers with the objective of increasing production of the product. Now, a subsidy to farmer reduces the effective cost of production and is expected to increases volume of production (Mochrie 2015). The effect of government subsidy to farmers is described with the help of demand and supply graph of an agricultural product.
The curve S1S1 shows market supply of the agricultural product. The associated demand for the agricultural product is explained by the curve D1D1. Without subsidy, market price is P* and market quantity is Q*. Under free market forces consumer surplus is given by the area A+B. Corresponding producer surplus is area C+D. Total surplus thus is equivalent to the area A+B+C+D. Now, suppose government offers a subsidy of “S” to the farmers. As the subsidy is given to the farmers, immediate effect of the subsidy is to shift the supply curve to the right to S2S2 by the amount of subsidy (Jain and Ohri 2015). Buyers now pay lower price of PB. Farmers on the other hand receives a higher price at PS. The difference in prices is equivalent to the amount of subsidy. The subsidy increase equilibrium quantity of the product from Q* to QS. At the lower price, consumer surplus now increases to A+B+C+F+G. The higher price increases producer surplus to B+C+D+E. The subsidy has a cost to the government. The cost equals subsidy times the quantity produced after subsidy. Total cost of subsidy to the government is given by B+C+E+F+G+H. The total surplus after subsidy thus is given as A+B+C+D – H. Total surplus after the subsidy thus lowers by the area H. This area represents deadweight loss resulted from misallocation of resources due to subsidy (Stoneman, Bartoloni and Baussola 2018).
Government can also provide subsidy to consumers to encourage consumption of the product. Subsidy by reducing effective price to buyers’ increase consumption and thus indirectly helps producers. The impact of a subsidy to consumers has a similar effect to that of a subsidy on farmers. This is explained in the figure below.
Before the subsidy, demand and supply condition in the market are given by D1D1 and S1S1 respectively. Equilibrium price and quantity in the market are given by P1 and Q1 respectively. At the free market equilibrium producer enjoy an area of surplus given by c+d. Consumers enjoys a surplus given by the area a+b. Total economic surplus before the subsidy thus is given by a+b+c+d. Now, suppose government offers a subsidy of “s” to the consumers. As the subsidy is given to the consumers, the immediate effect of subsidy is on the consumer demand. The demand curve shifts rightward by the amount of subsidy (Case, Fair and Oster 2013). The demand curve shifts to D2D2. The proposed subsidy increases price received by farmers to PS. Buyers on the other hand pays a much lower price at Pb. Surplus to the consumers after the increases to a+b+c+f+g. The surplus to producers after the subsidy increases to b+c+d+e. The effective subsidy increase market equilibrium quantity to Q1S. The given subsidy imposes a cost on government and indirectly on the taxpayers. Total cost the government is the area of the rectangle given by b+c+e+f+g+h. As the cost has been borne by taxpayer, this is deducted from total surplus. Total surplus after the subsidy is given as a+b+c+d-h. Total surplus thus reduces by the area “h” which represents welfare loss or deadweight loss to the society.
A subsidy given either to farmers or to the consumers of an agricultural product thus has a similar effect on market outcome. In both the cases, consumers pay a lower price while farmers receive a higher price and equilibrium output increases. In both the instances, total surplus is lowered by the area of deadweight loss. The only difference is on terms of initial impact on market. In the former, subsidy affects market supply and shifts the supply curve outward. In the latter, subsidy affects the market demand and shifts the market demand curve to the right.
Australian federal government owns Australian government debt. The government debt of Australia stood at $551.75 billion as recorded in April 2017. The government debt varied from week to week based on receipt, general and large sum outlays. Structural changes in the Australian economy are likely to leave government with a budget deficit amounting nearly 4 percent of GDP (Budget.gov.au 2018). The largest pressure in government revenue generates from steady increase in health expenditure. In the past decade, Australian government spent an additional $43 billion on healthcare. The government spending on health is expected to increase at a rate of 2 percent of GDP. The increase in spending on health is not due to increase in ageing population but rather is driven by the change in the practice of medicine. People of all age are more tend to visit doctors, have more operations and take more prescription drugs.
Other component contributing to budget deficit is increase in spending on education. Student performance however has been improved a little. The expenditure on welfare grew at a relatively slower pace. This is because of a low level of unemployment and a relatively slow growth for Youth Allowance, New start and parenting payments. The three other categories of welfares spending – family support, aged and disability pensions all increased by more than 50 percent in the past five years (Scutt, 2018). Increase in pension spending is again not due to demographic feature but due to government policy choice for benefiting pensioners.
Increase in cost is not the only reason for growing budget deficit. The revenue of Australian government is relatively weaker than that actually seems to be. The mining and company taxes and revenue from carbon prices are likely to be only 1 percent of GDP or $15 billion in a year. With a decline in mining investment and associated decline in mining price leads to fall in government revenue by 1 percent.
Australian government finds it difficult to run a surplus even during good times of the economy. There is temptation of government to spend money and please voters. Voters in Australia have come to expect that policies do not have any losers. The government spending in Australia as portion of GDP is 34 percent. This is lower by OECD standard. Globally, there are however big government that run with surpluses (theconversation.com 2018). With a sustained budget deficit future is likely to be more difficult. The strong economy of Australia gives the government more options compared to their counterparts overseas. However, the political leaders need to make people understand the importance of balanced budget for future prosperity.
Government spending and taxes are the two fiscal policy instrument used to boost economic activity. Government uses the fiscal policy instrument in order to influence aggregate demand with the objective of achieving goals such as economic growth, stability in price level and full employment. The fiscal policy might be expansionary or contractionary in nature. Expansionary fiscal policy is undertaken either by reducing tax or increasing government spending (Agenor and Montiel 2015). Aggregate demand curve here shifts rightward. Contractionary fiscal policy is undertaken either by increasing tax or by lowering government spending. Aggregate demand curve in this case shifts to the rightward.
Expenditure and taxation are thus two levers of government to set fiscal policy. When government changes spending or taxes the resulting shift in the aggregate demand can be smaller or larger than fiscal change. The multiplier impact tends to amplify the resulting impact of fiscal policy on aggregate demand (Uribe and Schmitt-Grohe 2017). The crowding out effect has a tendency to dampen the impact of fiscal policy on aggregate demand. In time of expansionary fiscal policy, government increases expenditure or lower tax or a combination of both. This leads to an increase in aggregate demand but the extent of increase in spending is subject to the size of spending or tax multiplier.
The government spending multiplier is a number that shown changes in aggregate demand following a change in aggregate demand. The multiplier effect is evident when an additional increase in expenditure leads to an increase income and consumption (Heijdra 2017). The tax multiplier captures the effect of change in taxes on aggregate demand. Lowering tax has a similar effect on income and consumption as increase in expenditure does.
Tax multiplier however is smaller than government spending multiplier. This is due to the fact that when government increases spending it directly purchase something. This causes full amount of change in the expenditure to be effective on aggregate demand. on the other hand, when government lowers tax, disposable income increases. Part of the disposable income though is consumed but part is saved. Portion of money that is saved does not reflect in the multiplier.
The figure above explains effect of an increase in government expenditure in an economy. The initial equilibrium in the economy occurs at the point E obtained from the intersection of aggregate demand and aggregate supply. The equilibrium real GDP in the economy is Y* and that of the price level is P*. Now suppose, there is an increase government expenditure. This shifts the aggregate demand outward (Mankiw 2014). The aggregate demand curve however does not shift to the full extent of spending. It is discounted by marginal propensity to consume which is less than 1. Real GDP increases to Y1 and that of price level increases to P1.
The decline is tax though has a similar effect like expansion of government expenditure, the shift is aggregate demand is lesser compared to that under government expenditure (Goodwin et al. 2015). This is because of a smaller multiplier effect. Real GDP increases to Y2 and price level increases to P2.
References
Agénor, P.R. and Montiel, P.J., 2015. Development macroeconomics. Princeton University Press.
Baumol, W.J. and Blinder, A.S., 2015. Microeconomics: Principles and policy. Nelson Education.
Blad, M.C. and Keiding, H., 2014. Microeconomics: Institutions, equilibrium and optimality (Vol. 30). Elsevier.
Budget.gov.au 2018. Appendix D: Historical Australian Government Data. [online] Budget.gov.au. Available at: https://www.budget.gov.au/2015-16/content/myefo/html/16_appendix_d.htm [Accessed 5 Feb. 2019].
Case, K.E., Fair, R.C. and Oster, S.E., 2013. Principles of microeconomics. Pearson Higher Ed.
Cowell, F., 2018. Microeconomics: principles and analysis. Oxford University Press.
Cowen, T. and Tabarrok, A., 2015. Modern principles of microeconomics. Macmillan International Higher Education.
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retailworldmagazine.com.au 2018. Spotlight on Australia’s supermarkets and grocery industry – Retail World Magazine. [online] Retail World Magazine. Available at: https://www.retailworldmagazine.com.au/spotlight-australias-supermarkets-grocery-industry/ [Accessed 5 Feb. 2019].
Scutt, D. 2018. The growth in Australian government debt since the GFC, in one chart. [online] Business Insider Australia. Available at: https://www.businessinsider.com.au/the-growth-in-australian-government-debt-since-the-gfc-in-one-chart-2018-5 [Accessed 5 Feb. 2019].
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theconversation.com 2018. Australian governments face a decade of budget deficits. [online] The Conversation. Available at: https://theconversation.com/australian-governments-face-a-decade-of-budget-deficits-13616 [Accessed 5 Feb. 2019].
Uribe, M. and Schmitt-Grohe, S., 2017. Open economy macroeconomics. Princeton University Press.
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