Elasticity of Demand and Cross-Price Elasticity - Essay Example

A. DEFINITIONS Elasti of demand: It is defined as the relation between any change and variation in the prices of goods or services that wouldultimately affect the quantity demand of those particular goods or services. “Percentage change in quantity demand of good due to percentage change in price of that good”(Mankiw, Principles of Economics, 2011) 2. Cross-price elasticity: If the quantity demanded of one good incurs change due to change in the price of another related good then it is termed as cross-price elasticity. “Percentage change in quantity demand of one good due to percentage change in price of another good”(Mankiw, Principles of Microeconomics, 2011) However, the cross price elasticity depends on the nature of the products. It is the coefficient of Cross-price elasticity that not only determines the relationship between two products but also signals us that whether the goods are substitute or complementary to one another. I. Substitute goods: substitute goods are those goods that have same marginal utility or provide the same satisfaction to the consumer. For instance, Coke and Pepsi Let us suppose, if the price of Coke increases then people will substitute their utility to Pepsi and hence, demand of Pepsi will increase. Complementary goods: These are goods that have a mutual use or are used jointly. Prominent ones include printer and cartridge, car and oil, razor and blade etc. Since, car is useless without petrol hence if price of petrol increases then the demand for car will decrease. THE DIFFERENCE BETWEEN SUBSTITUE AND COMPLEMENTARY GOOD IS SIMPLY EXPLAINED AS: In substitute goods, if the price of one good increases then the quantity demand for another good will increase. Since both the goods provides same satisfaction. It does not matter to a consumer to consume any of them. Whereas; in complementary good if price of one good increases then the demand for other good will decrease as one good is useless without another. 3. Income elasticity It is defined as the rate of change in quantity demanded of goods or services to the change in income of individual. Or; “percentage change in quantity demand due to percentage change in income of consumer”(Forgang & Einolf, 2007) The coefficient of income elasticity does not only help in determining the relationship between income and quantity demanded but it also helps us to figure out whether the good is inferior or normal. I. Inferior good: These are those goods whose demands have either little or no affect on its consumption due to any change in the income of a consumer. We can also say that as the income of a consumer will increase, he will consume less of those goods Example: basic goods like an ordinary hamburger, an ordinary wrist watch, a bicycle etc. II. Normal goods: these are those goods that are affected by any change in income of a consumer. As the income increase the demand for these goods also increase. : luxury goods like luxury car, blackberry/apple phones, airway tickets, vacations etc B. Elasticity coefficients: Elasticity of demand: The coefficient of elasticity of demand is negatively correlated. They have an inverse relationship. As the price increases the quantity demand decreases and vice versa. Cross-price elasticity: The coefficient of Cross-price elasticity helps us determine whether the good is complementary or substitute to one another and if the elasticity has negative sign it means that the goods are complementary. Where as if the goods are strong substitutes to each other then there will be a positive sign(this can be easily understand from the example given in part A that there is a positive relationship between price of Pepsi and quantity demand of coke). Income elasticity The coefficient of Income elasticity can be either greater than 1, proportional to 1 or less than If the percent change in the quantity demanded is greater than the percent change in consumer income, the demand is said to be income elastic, and if less than one then it is income inelastic. 1. If the elasticity is NEGATIVE, it means that the goods are inferior in nature. For Example: you consume two breads daily as per requirement. Now, if your income increases you will not consume four breads instead of two as your stomach gets filled in two. Similarly, when the elasticity is POSITIVE it means it is a normal good (luxury good). As your income will increase you will demand more branded goods. Instead of a normal coffee you would like to enjoy coffee from Starbucks, designer dresses and Rolex watches. The coefficient of income elasticity for inferior good is always negative. (As income and quantity demand moves in opposite direction). And positive for normal goods (income and quantity demand moves in same direction) C.DIFFERENCE AMONG THE DETERMINANTS: The price elasticity of demand defines the relationship between price and quantity demanded. In contrast; The income elasticity of demands helps determine the relationship between income and quantity demanded. Whereas, the cross-price elasticity of demand show the relationship between two related commodity SIGNIFICANS: All above elasticity of demand plays a significant role in understanding the behavior of consumer or individual under each scenario. We can also predict a possible outcome with the changes in either of the determinant. D. IMPACT ON DEMAND ELASTICITY UNDER GIVEN SITUATION 1. Availability of substitutes: (Demand elasticity will be greater) If the substitute for a particular product is open to a consumer, then the demand would be elastic which means that the increase in price of product ‘A’ will decrease its quantity demanded and people will be willing to consume more of the substitute good as it is cheaper than product ‘A’ and also provides equal utility and vice versa. We know that there is always a positive relationship between price of one good and quantity demanded of the substitute good. Hence if price of a good ‘A’ increases then the quantity demand of its substitute will also increase. Example: if the price of chicken increases, then people will start consuming beef/mutton or even pork and the quantity demand for beef/mutton will increase. (E, 2007). 2. Share of consumer income devoted to a good: The larger is the share of consumer’s budget to a particular good, the more likely it is that consumers will look for substitutes when the product’s price goes up. If a large share of the budget is devoted to an elastic good, then the consumer will look for a substitute if the price of that good goes up. 3. Consumer’s time horizon: The time horizon for a consumer or the time taken for analysis will also affect price elasticity of demand. It depends on case to case whether the time given to the customer would impact the demand for the product or not. For instance, if there is a discount on purchase of Pepsi cans, people will react to it and buy many cases of Pepsi at once. Consumers know that the price of Pepsi would increase again in the future. However, long term decline in price will cause less effect on the quantity demanded as the consumers know that the lowered price is long-term in nature and it would not change in the near future. On the other hand, there are goods whose price elasticity is higher in the long run as compared to short run. For example, gasoline consumption in the third word countries. E. Example 1. Availability of substitutes Example: if the price of motor bike increases, then people will start shifting to bi-cycles and the demand for bi-cycle will increase. (E, 2007). From a business decision making perspective, it is essential to note for any manager that the product which they sell should be priced in relation to its competitors or substitute products because as the product price of good ‘A’ increases, the demand for its substitute will increase. It has a logical explanation as consumers would refrain from buying a product of higher price if its substitute provides the consumer with same utility in lesser price. 2. Share of consumer income devoted to a good: For example: if a consumer devotes high percentage of its budgeted expenditure on consumption of meat then the consumer will switch to chicken if the price of meat increases. This is because of the fact that the price increase of meat will increase the overall expenditure therefore, in order to control the expenditure; the consumer will switch to the substitute. The rationale behind the above analysis suggests that consumers would never like to increase their overall expenditure therefore, if a large chunk of their income is devoted to a product ‘A’, they would be eyeing its substitute to decrease the impact of an increase in price of product A. As managers, one should always keep the consumer demographics in mind before passing an increase in price to consumers. 3. Consumer’s time horizon For example, the price elasticity of petrol is much greater in the long run than in the short run. In the short run, it is cumbersome to find an alternative to petrol as most of the people in developed countries own cars and to find an alternative to fuel is not easy. Therefore, even though there is a price hike, the demand for the product will not fall drastically. However, in the long run, people would try to look for a substitute, may be solar cars, or buy fuel efficient cars. The logical impact on decision making of products like petrol would be based on the above analysis. The price elasticity of a product with no ready substitute available would be low however, if the price inc/dec is for a longer period of time, then consumers would eventually shift to an alternate to reduce their cost as endorsed by the above example. F. Differentiation: PERFECTLY INELASTIC DEMAND: Perfectly inelastic demand exists when people have no close substitutes available. It may refer to normal goods at times. The increase in price has no or little affect on its quantity demand. Example: salt (it has no close substitute) As the graph above clearly shows: An increase in price of good from $20 to $21 did not affect the quantity demand of the good. PERFECTLY ELASTIC DEMAND: Perfectly elastic demand refers to a situation in which people have more close substitute or alternatives available. The increase in price of a good or service will decrease the quantity demand of that product. The graph above illustrates that when the prices increases by $20, quantity demanded is zero. However, when price is set below $20, quantity demanded increases infinitely.(Duffy, 1993) G.THE RELATIONSHIP BETWEEN ELASTICITIES OF DEMAND AND TOTAL REVENUE: Price Rise Price Decline Elastic (E>1) TR decreases TR increases Unit Elastic (E=1) TR constant TR constant Inelastic(E Read More