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Additional Reading

Additional Reading

I. Texts for Comprehension

A Model of the Demand for Tube Journeys

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 analyze the relationship between tube fares and revenue from running the tube: how would you have analyzed 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.

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 traveler behavior 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

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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 rose 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?

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(known as consumption) and save some as well. Savings take money out of the circular flow – a withdrawal.

What about businesses? They are not likely to spend all their revenue on rent and wages. They will also invest some in machinery and equipment. These are used to produce goods and services which increase money in the economy – an injection. There are a number of injections and withdrawals in a complex economy. Injections can include:

investment (I) – spending on fixed capital, such as machinery and factories, and circulating capital, such as stocks and work-in-progress which enter the circular flow;

government spending (G) – spending by government on new schools and motorways or subsidies to firms;

exports (X) – goods and services sold abroad, earning money for the UK which enters the circular flow of income.

Withdrawals can be:

savings (S) – money saved by households;

taxation (T) – money taken out of the economy from businesses and households by government through taxation;

imports (M) – goods and services coming into the country paid for by money leaving the circular flow.

BUSINESSES

Figure 2. The circular flow of income showing injections and withdrawals

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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 1. The table confirms that the

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Money

Money makes the world go round, to paraphrase an old saw. But money is also a wonderfully mysterious idea. Think of it: a group of people, most of whom have never met each other, have agreed that a piece of paper is worth something and can be used to acquire goods and services. A dollar buys you a cup of coffee. Why? Because we’ve all decided that it works best to believe that a piece of paper is good for a cup of coffee.

It wasn’t always so. Long ago, before money, or currency, before paper and coins, people traded things: a bushel of wheat for a ceramic bowl, for example. This barter system worked fine, but it had disadvantages. It wasn’t practical to lug around bushel baskets of grain all day long. So bartering evolved to using smaller, more transportable objects. Some people use beads. Others used gems. The value of the various trinkets used varied widely, meaning that most transactions still required quite a bit of negotiation.

Gold became a popular currency before the widespread adoption of paper money. In 1091 B.C.E., the Chinese approved the use of gold bars as a form of money. The Roman Empire issued gold coins. In 1284 Vienna introduced the gold ducat, which would be a dominant world currency for almost five centuries.

The transition to paper money moved along an erratic path. China introduced paper money in the ninth century, but its use died out about five hundred years later, when rampant printing of currency led to terrible inflation. When too much currency is printed, the value of each piece of currency declines. As the amount of currency increases, it takes more currency to buy the same thing. China didn’t return to paper money for several hundred years.

Paper arrived in the United States in 1690, when colonists in Massachusetts printed notes. For a period of time, paper money in the United States and elsewhere could be converted into something else, usually gold. In other words, if someone gave you five dollars for a cup of coffee, you could take that five dollars and redeem it for gold or some other precious metal. Paper money’s convertibility helped provide assurance to those who used the money in transactions that it was worth the number printed on the paper.

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