Unit 9 Text b

 

 

  The income statement shows the flow of money during the given year. But we also describe the position the firm has reached as a result of all its past trading operations. We call this document the balance sheet. The balance sheet.

  Now, essentially the balance sheet lists the assets the firm owns. It also lists its liabilities. What? LIABILITIES. OK? Good. Now by doing this the balance sheet provides us with a picture of the firm at a particular point of time, for example at the end of a year. I’ll now go through a balance sheet with you, so take a moment to look at this. It’s the balance sheet of Snark International on 31st December, 1987.

  Let’s start with assets. Assets are what the firm owns. These assets are listed on the left, as you can see. Snark, this firm, has some cash in the bank. That’s one asset. It’s also owed some money by its customers, who haven’t paid yet. This money is shown as accounts receivable. That’s another asset. Yet another asset is the large inventories it has in its warehouses. Not only that, but it also owns a factory. This factory originally cost a quarter of a million, but notice that, because of depreciation, it’s now only worth two hundred thousand. Of course, it also has other equipment  desks, perhaps, or machinery  which originally cost Snark three hundred thousand. Again because of depreciation, this equipment is now worth a hundred and eighty thousand. So we can say, after adding all these assets up, that Snark is worth five hundred and ninety thousand.

  Now let’s take a look at liabilities. Liabilities are what the firm owes. These liabilities are shown on the right of the balance sheet, as you can see, starting with accounts payable. These are bills that Snark owes but  has not  yet paid. It also hasn’t yet paid some salaries, some fifty thousand pounds’ worth. That’s also a liability. Then, there is a mortgage on the factory of a hundred and fifty thousand which it has negotiated with an insurance company. Finally there is a bank loan. That’s for shorter-term cash needs. Adding all that up, we can see that Snark has liabilities, or debts, of three hundred and fifty thousand. So we can say that the net worth of Snark, note that term ‘net worth’, is two hundred and forty thousand. That’s the excess of its assets over its liabilities.

  Some of you may be wondering why Snark’s net worth is shown as a liability rather than an asset. The reason is simply because the firm is owned by its shareholders. So the net worth is really owed to them. It is a liability of the firm to the shareholders.

  Now let’s imagine you have lots of money and you want to buy Snark. To make what we call a take-over bid, in fact. How much do you think you should offer? Eh? Well, you might think of offering two hundred and forty thousand, which is, after all, the net worth of the company. But I think probably not. Why not? Well, Snark is a live company. It’s got good prospects for future growth. It’s got a proven record. You have to remember you’re not just bidding for its physical and financial assets, less of course its liabilities. You’re actually bidding for the firm as a going concern. You will also get its reputation. Its customer loyalty. And a great many other things, all intangible. All these intangibles, like reputation and customer loyalty, we economists call goodwill.

Case Study

 

Case 1

 

In the early 1980s there was a controversy over the “Fares Fair”  policy of cutting bus and tube fares in London. Some people thought low fares would increase passengers and bring in extra revenue for London Transport, which runs the bus and tube services. Others thought that low fares would lead to disastrous losses in running London Transport. Eventually the matter was referred to the courts. Suppose you had been a consultant brought in to analyse the relationship between tube fares and revenue from running the tube: how would you have analysed the problem?

  To organize our thinking, or - as economists describe it - to build a model, we require a simplified picture of reality which picks out the most important elements of the problem. We begin with the simple equation.

 

Total fare collection = fare  number of passengers

(1)

 

In this stark form, equation (1) emphasizes, and thus organizes our thoughts around, two factors: the fare and the number of passengers. London Transport directly controls the fare, but can influence the number of passengers only through the fare that is set. (Cleaner stations and better services might also encourage passengers, but we neglect these effects for the moment.)

  It might be argued that the number of passengers is determined by habit, convenience, and tradition, and is therefore completely unresponsive to changes in fares. This is not the view or model of traveller behaviour that an economist would initially adopt. It is possible to travel by car, bus, taxi, or tube, and decisions about a mode of transport are likely to be sensitive to the relative costs of the competing alternatives. Thus in equation (1) we must not view the number of passengers as fixed but develop a ‘theory’ or ‘model’ (we use these terms interchangeably) of what determines the number of passengers. We must model the demand for tube journeys.

  We can study the theory of demand in detail. Applying a little common sense, we can probably work out the most important elements straight away. First, the fare itself matters. Other things equal, higher tube fares reduce the quantity of tube journeys demanded. Of course, what matters is the price of the tube relative to the price of other means of transport  - cars, buses, and taxis. If their prices remain constant, lower tube fares will encourage tube passengers. Rises in the price of these other means of transport will also encourage tube passengers even though tube fares remain unaltered.

  We now have a bare-bones model of the demand for tube journeys. We summarize this model in the formal statement:

 

Quantity of tube journeys demanded = f(tube fare, taxi fare, petrol price, bus fare, ...)

(2)

 

This statement reads as follows. The quantity of tube journeys ‘depends on’, or ‘is a function of’, the tube fare, the taxi fare, petrol prices, bus fares, and some other things. The notation f (1) is just a shorthand for ‘depends on all the things listed inside the brackets’. In equation (2) we have named explicitly the most important determinants of the demand for tube journeys. The row of dots reminds us that we have omitted some possible determinants of the demand for tube journeys in an effort to simplify our analysis. For example, tube demand probably depends on the temperature. It gets very uncomfortable in the underground when it is very hot. Since the purpose of our model is to study changes in the number of tube passengers, it will probably be all right to neglect the weather provided weather conditions are broadly the same every year.

  To answer our original question, it is not sufficient to know the factors on which the demand for tube journeys depends. We need to know how the number of passengers varies with each of the factors we have identified in our model. Other things equal, we assume that an increase in tube fares will reduce tube passengers and that an increase in the price of any of the competing modes of transport will increase tube passengers. To make real progress, we shall somehow have to quantify each of these separate effects. Then, given predictions for bus and taxi fares and the price of petrol, we would be able to use our model to predict the number of tube passengers who would want to travel at each possible tube fare that might be set by London Transport. Multiplying the fare per journey by the predicted corresponding number of journeys demanded at this fare, we could then predict London Transport revenue given any decision about the level of tube fares.

  Writing down a model is a safe way of forcing ourselves to look for all the relevant effects, to worry about which effects must be taken into account and which are minor and can probably be ignored in answering the question we have set ourselves. Without writing down a model, we might have forgotten about the influence of bus fares on tube journeys, an omission that might have led to serious errors in trying to understand and forecast revenue raised from tube fares.

 

  You have read the text. Check your understanding.

1)  What controversy was there in 1980 over the ‘Fares Fair’ policy of cutting bus and tube fares in London?

2)  How would economists organize the solution of fares problem?

3)  How can the equation one organize our thoughts?

4)  What organization directly controls the fares?

5)  How can London Transport influence the number of passengers?

6)  Is the number of passengers responsive to the changes in fares?

7)  What theory or model should an economist develop to solve the problem of the number of passengers?

8)  What is the relationship between fares and demand for tube journeys?

9)  What is the dependence of the quantity of tube passengers on the fares of other means of transport?

10)For what purpose can we use the model given in the text?

11)How could we predict London Transport revenue?

12)What is the importance of building the model?

 

Case 2

 

Leipzig East Germany's second largest city, has attracted attention from office developers as it changes from a planned to a market system. The city has a shortage of office space. Most of its existing space is obsolete compared with Western standards. Also, if Leipzig is to achieve the status of other German cities, it needs to develop another 2 or 3 million sq.ft of office space. Developers are receiving a number of incentives, including grants, favourable tax treatment, EC regional grants and subsidised  lending rates. Another attractive feature for developers is the state of rents. Because of the shortages rents have risen sharply  and Leipzig is seen as a good investment opportunity by many property speculators.

However, there have been problems as the city copes with the  transition.

        Pollution from open cast mining in the countryside has disfigured much of Leipzig's building stock.

        Inadequate building stock has resulted in housing shortages discouraging skilled workers from moving to the city. Hotel shortages have also restricted the number of visitors to Leipzig.

        Poor transport infrastructure.

        Many of the young and relatively well educated members of the population have migrated from the city. This has contributed to a population decline from 713,000 to 511,000 over a 50 year period.

        Land ownership disputes have resulted in delays and frustration as land and property is transferred from the state to the private sector.

        There has been a flood of goods from West Germany into the city.

 

You have read the text. Answer the questions.

(a)                    How far are the problems facing Leipzig a result of it being formerly part of a planned economy?

(b)                   How might cities such as Leipzig overcome the problems of changing from a planned to a mixed economy?

 

Case 3

 

THE DETERMINANTS OF PRICE ELASTICITY

 

What determines  whether the price elasticity of demand for a good is high (say, -5) or low (say, -0,5)? Ultimately the answer  must be sought in consumer tastes. If it is  considered  socially essential to own a television, higher  television  prices may have little effect on quantity demanded. If televisions  are considered a frivolous luxury, the demand  elasticity  will be much higher. Psychologists and sociologists may  be able to explain more fully than economists  why  tastes  are  as they are. Nevertheless, as economists, we can  identify some considerations likely to affect consumer  responses to changes in the price of a good. The most important consideration is the ease with which consumers  can  substitute  another  good that  fulfils approximately the same function.

  Consider two extreme cases. Suppose first that the price  of all cigarettes  is raised 1 per cent, perhaps because the cigarette tax has been  raised. Do you  expect the quantity  of cigarettes demanded to fall by 5  per cent or by  0,5 per cent? Probably the latter. People  who can easily quit smoking  have  already done so. A few smokers  may  try to  cut down  but this effect  is unlikely  to be large. In contrast,  suppose  the price  of one particular  brand of cigarettes is increased by 1 per cent, all other brand prices  remaining unchanged. We should now expect a much larger quantity  response from buyers. With so many other  brands available  at  unchanged prices, consumers will switch away from  the more expensive  brand to other brands that basically fulfil the same function of nicotine provision. For a particular cigarette brand the demand elasticity could be quite high.

  Ease of substitution implies a high demand elasticity for a particular good. In fact, our  example suggests a general rule. The more narrowly we define  a commodity (a particular brand of cigarettes rather  than cigarettes in general, or  oil rather than energy as a whole), the larger will be the price elasticity of demand.

 

MEASURING PRICE ELASTICITIES

 

To illustrate these general principles we report estimates of price elasticities of demand in Table 4.3. The table confirms that the demand for general categories of basic commodities, such as fuel, food, or even household durable goods, is inelastic. As a category, only  services such  as haircuts, the theatre, and sauna bath, have an elastic  demand. Households simply do not have much scope to  alter the broad pattern of their purchases.

  In contrast, there is a much wider variation in the demand elasticities for narrower definitions of  commodities. Even then, the demand for some  commodities, such  as dairy produce, is very inelastic. However, particular kinds of services such as entertainment and catering have a much more elastic  demand. Small changes in the relative price of restaurant meals and theatre tickets  may lead households to switch  in large  numbers  between eating  out and going to the theatre, whereas the demand for getting out of the house on a Saturday evening may be relatively insensitive to the price of all Saturday  night activities taken as a whole.

 

TABLE 4-3. Estimates of Price Elasticities of Demand in the UK

Good (General Category)	Demand Elasticity	Good (Narrower Category)	Demand Elasticity
Fuel and light	0,47	Dairy produce	0,05
Food	0,52	Bread and cereals	0,22
Alcohol	0,83	Entertainment	1,40
Durables	0,89	Expenditure abroad	1,63
Services	1,02	Catering	2,61

 

  You have read the text. Check your understanding.

1)  At what numerical quantities of the price elasticity is demand elastic or inelastic?

2)  When do economists say that demand is unit - elastic?

3)  What is the key piece of information which is required in setting prices?

4)  What determines whether the price elasticity of demand for a good is high or low?

5)  For what categories of commodities is demand usually inelastic?

6)  What is the most important consideration which affects consumer responses to changes in the price of a good?

7)  What is the demand elasticity for narrower definitions of commodities?