Price Elasticity of Demand - Coursework Example

Price Elasticity of Demand Price elasticity of demand refers to how sensitive the amount of a good or service that is highly needed respond to change in prices. A good or service with many close substitutes will have its demand being more elastic since the customers can very simply adjust to another good due to increase in price of that good in comparison to other goods in the marketplace. On the contrary, a produce with little or no close substitutes will have inelastic demand since the customers have no other produce to adjust to. Price elasticity of demand (Ed) = percentage in amount demanded Percentage of change in price = Δqd/qd × (Δp/p)-1 Ed gives Δ% in amount or quantity demanded in answer to a 1% Δ in prices. Ed of a given good is used to forecast the rate of a tax on that good and also to understand that, revenue can only be maximized if Ed is 1. In summary, Ed measures % Δ in amount or quantity demanded as a result of 1% Δ in price (Ivan, 2007). Income elasticity of demand Income elasticity of demand can be defined as the measure, connection or relationship between Δ in quantity demanded for good y and Δ in actual income.  Income Elasticity of Demand (IED) = % Δ in demand/ % Δ in income Income Δ shifts the demand curve implying Δ in demand. Cross Price Elasticity (CPE) is the rate at which quantity or amount demanded of one good respond as a result of Δ in price of another commodity z (Ivan, 2007). CPE = (% Δ in Quantity Demand for Good)/ (% Δ in Price for Good z) For example, if the price of fuel increase by 20%, the reaction would be that the demand of new Vehicles that are fuel inefficient will reduce by 40% and therefore cross elasticity of demand will Be -2 (-) cross elasticity represents two commodities that are complement, while (+) cross elasticity represent two substitute commodities. In above example, the two commodities, fuel and vehicle are complements to mean that one commodity is used by the other. In such a case, cross elasticity of demand is (-) as evidenced by reduction in demand for vehicles when fuel price is raised. Everybody needs salt in food and nothing else can substitute salt. Therefore, when the price of salt goes high, then more is spent on it. Also the same case would be for people who want to build stronger and permanent stone buildings. They must need cement and therefore if the price of cement increases, more will be spent on it rather than thinking of adjusting to another produce. Two commodities are substitutes when cross elasticity of demand is (+) to mean that when the price of one commodity increases, the demands of the other commodities rise. For instance if the company that makes Rhino matches increase their prices significantly, then the customers are most likely to adjust to other types of matches rather than paying more for the same Rhino match at an increased price. The same would apply if the Sony Company that manufactures electronics increases the prices of their products, customers will opt for similar products manufactured by different companies and which are sold at fair price. This is because the other companies can produce substitutes that meet the customers’ demands. Elasticity determinants: the availability of substitutes, substitutability, and time has to be put into consideration because even with the increase in prices and the customers turning to substitutes, every business will continue running. Hence, for the commodities with many substitutes, the merchant will have to create special offers from time to time to attract the customers unlike the commodities with inelastic demand. Then some products like salt signify a minute portion of the customer’s financial plan resulting to reduced concentration being given to its price. Also if a commodity is the only option in the market, then its substitutability becomes very minimal. e.g roller skates. If they are the only skating gadgets then the customers will not be very perceptive to its price variations since after all they require them for skating. Elasticity coefficients quantity demand elasticity, cross-price elasticity and income elasticity and therefore take into consideration elasticity response realized between two variables that have a solo value. These coefficients are calculated using the following formula: Coefficient of elasticity (λ) = %Δ in variable y/%Δ in variable z Range of Elasticity is usually divided into five elasticity categories namely unit elastic, perfectly inelastic, relatively elastic, relatively inelastic, and perfectly elastic. Unit Elastic (E = 1) Perfectly inelastic (E = 0) Relatively elastic (1 < E < ∞) Relatively Inelastic (0 < E < 1) Perfectly Elastic (E = ∞) For perfectly elastic (E = ∞), infinitesimally small Δ in price results infinitely large Δ in amount demanded. For relatively elastic,(1 < E < ∞), small Δ in price result in comparably large Δ in quantity. For unit elastic (E = 1), any Δ in price result in an equal change in amount. For relatively inelastic,(0 < E < 1), relatively large Δ in price results in relatively small Δ in quantity. For perfectly inelastic, (E = 0), quantity demanded is not affected by Δs in price For Inelastic Range, Ed>1; when price is high, total revenue is low (inverse of each other) and the % quantity demanded is greater than the % Δ in price. The negative value of elasticity is overlooked to allow for comparison with supply elasticity and also to be able to classify quickly the elasticity as either perfectly inelastic, unit elastic, perfectly elastic, relatively inelastic, and relatively elastic. However in cross-price elasticity and income elasticity, the λ value (negative or positive) is significant. For substitute goods, cross-price elasticity of demand λ is (+), the sale of commodity K moves in same direction as Δ in price of commodity K. For Substitute Goods also, a larger (+) cross-price elasticity λ implies a higher exchangeability between the two commodities. For complementary commodities, cross-price elasticity λ is (-) and therefore, a rise in price of commodity K reduces the demand for commodity K. A larger (-) cross-elasticity λ implies higher complementary between the two commodities (Thomas, 2010). Price elasticity of demand is also affected by the consumer time horizon (time required to analyse the effects of a price Δ). For example, the elasticity of petrol is greater in the long run than in the short run. Therefore, it may be difficult to get a substitute for petrol as many people own cars and other vehicles that use petrol and many workplaces are far away from residential areas. Sometimes commodities are more elastic in the short run and therefore, consumers will react to this by buying many units for fear that the price will again rise in the future. On the other hand, long-term reduction in price causes negligible effect on the quantity demanded, because in many instances the consumers know that it will take a longer time for the price to increase. Income elasticity is also closely related to the share of consumer income devoted to a good. The income distribution and amount of product sold can be correlated to buyers from different economic backgrounds. Therefore when a customer of a particular economic bracket has an increased income, how he/she buys products changes to match the new income bracket. In cases where income share elasticity is defined as (-) %Δ in individuals given(+) Δ % increase in income bracket, the resultant in income elasticity becomes the estimated value of the income-share elasticity with respect to the distribution of income of buyers of the commodity. Consumers will therefore react to price increase on a good that requires a significant portion of the consumer's income by decreasing usage of such products and also may opt for cheaper substitutes. In addition, no effect will be felt on price increase on commodities that require small fraction of consumer income. Higher prices decrease the real spending power of consumer income and this decreases the quantity demanded. Changes in prices of goods that take a greater part of income impact greatly on the consumer capability to buy such goods. For example, if the price of houses were to increase in America, then the ability to buy houses will decrease. Independent Goods have zero or negligible cross-price elasticity λ to imply the commodities in question are not related. Therefore a Δ in one commodity price has no effect on the demand of the other commodity price. Coefficient of cross- price elasticity is important for both government and business because the demand for their commodities is directly affected by other commodities The coefficient of income elasticity is negative for inferior goods. Therefore negative implies that the goods in question are inferior, for example used clothing. It further indicates that income and amount or quantity that is highly needed moves in contrary routes. That is, when income rises, demand for commodities reduces implying the inferiority of the commodity. For standard commodities, income elasticity λ is positive to imply that the commodity is normal and therefore, income and amount demanded all move in similar direction. Coefficients of income elasticity of demand provide insights into the economy and helps explains why events are happening in the economy (Thomas, 2010). Perfectly inelastic demand refers to a situation where if reduction or increase in commodity prize results in no Δ in quantity of product demanded and therefore, the price elasticity of demand is zero. Demand curve is vertical to implying that; Δ in price will not result in corresponding increase in demand. On the other hand perfectly elastic demand refers to a situation where a commodity is only demanded at a specific price and therefore, Δ in price results in reduction of quantity demanded to zero. In situations where the demand has price inelasticity, a rise in price results in a rise in total revenue because positive Δ in price causes smaller negative Δ in quantity demanded ( Thomas, 2010). From graphs attached; Elastic Ed>1: When quantity demanded increases up to 4, prices decreases up to 50 while total revenue increases up to 200 Unitary Ed=1: When quantity demanded increases up to 5, price is 40 and does not affect the total revenue ie. Remains at 200 Inelastic Ed1 Price ↓; TR ↑ Price ↑; TR ↓ Price &revenue movement is opposite Large % of demanded quantity than % Δ of price Inelastic Ed Read More