Concepts of Supply and the Elasticity of Demand - Essay Example

Concepts of Supply and the Elasticity of Demand The first economic determinant of supply and demand which will be analyzed is that of the elasticity of demand. This term most closely relates to the demand for something that is driven and provided for by the changes in the item price. In other words, the willingness of the buyer to seek the given good or service is a direct and measurable result of the pricing at which the given item is offered. Figure 1.0 below shows in detail what the elasticity of demand portends for the price and quantity of a given item as a function of graphic analysis. Of course it cannot always be understood that price elasticity of demand will be a primal motivating factor. Due to the fact that the market for many goods and services has a very inelastic price elasticity of demand, the actual level of demand that consumers express bears little relation to the price that is being offered for the commodity. Figure 1.0 Source: Marban, Zwaan, Grigoriev, Hiller, & Vredeveld, 2012 This particular graph is indicative of an elastic demand curve. It is important to bear in mind that the demand curve is not steeply sloping; rather, it exhibits a gradual decline as price fluctuates. Naturally, determinants such as consumer time horizon will greatly impact the total elasticity that is represented in the above representation by elongating and flattening the demand curve as a result of the fact that the consumer believes that the cost is likely to change within the near future. Similar changes to the demand curve will also be noted if/when changes to the consumer’s income are noted and/or if the availability of substitutes weakens or strengthens the demand that has hitherto been illustrated. Cross price elasticity Similarly, “cross price elasticity” is a term that is used to measure the responsiveness of the demand for a given good to the change in price of a competing good. This level of change is given as a percentage point and is derived as a function of measuring the percentage change in price of the secondary good/commodity. As a quick example, if the price of shipping were to increase by 10% and the price of the finished good itself were to decrease by 25%, the following formula would be used to calculate the cross price elasticity of the given good: -25/10= -2.5. In this way, the reader can see the level to which competing goods/commodities play with relation to the elasticity of demand for a given product within the marketplace. An important fact to note is that the question of whether the cross price elasticity is positive or negative denotes whether or not the given good/commodity in question is either complimentary or supplementary of the primary good. Negative cross elasticity means that two products are compliments whereas a positive means that they are supplementary to each other. Figure 2.0 represents the graphical interpretation of cross price elasticity. Figure 2.0 Source: Arak & Spiro, 1973 Income elasticity Thirdly, this brief analysis will consider the term “income elasticity.” This can be described as the responsiveness of demand for a given good or service to the change in the overall income of the individuals who are demanding the item. In much the same way as the previous term was calculated, income elasticity is calculated as the percentage change in the demand as compared to the percentage change in the income of the affected consumer base. In this way, the observer could calculate a 10% increase in income as compared to the demand for a good increasing by 20% as 20%/10%=2. Figure 3.0 illustrates the decreasing demand for a product as a function of reducing incomes of the affected population that would otherwise serve as the primary consumers of the given good/service/commodity. Figure 3.0 Sources: Fouquet, 2012 Increases in consumer spending/income would mean that one would realize a net increase in buying and spending habits thereby correlating to an increase in the good demanded as a function of the elasticity of income which has been described. Similarly, if an increase was noted to income elasticity then one would expect the demand for substitute goods to decrease. Finally, with relation to increase of the price of the good would have different factors depending on whether income elasticity is high or low. In economic terms, normal goods refer to those goods which demand increases when the income of the affected market increases. Conversely, as one might expect, with normal goods, the demand for those goods consequently decreases when income of the affected market decreases as well. What is especially noteworthy is that even though the demand increases and decreases, the price remains constant regardless of the economic income level of the affected marketplace. Therefore, normal goods are indicative of income elasticity of demand. As a means of introducing and acquainting the reader with a few examples of normal goods, one could consider the case of diamonds, new cars, or a brand name luxury item which price is unaffected regardless of the income or market dynamics of the affected purchasing groups. Below Figure 4.0 indicates the means whereby the marketplace responds to changes within the consumer’s income as a function of demand as well as price. Figure 4.0 Source: Khan, 2012 Inferior goods, on the other hand, do not necessarily denote an item that is of poor quality or prone to an inherent flaw. Rather, inferior goods are those in which income and demand are related inversely. In other words, an increase in income means that a decrease in demand for a given item will necessarily occur. On the flip side, a decrease in income means that an increase in demand for the “inferior good” will necessarily ensue. Although using the term “substitute product” is incorrect due to the fact that this term already has a defined economic meaning, the reader can understand inferior goods to be necessities that individuals buy and have bought as a means to provide for themselves in lean times. Potatoes, bread, and utilitarian goods that do not represent the high end of luxury or fashion would all be examples of inferior goods. As one might expect, and has been noted in the definition, the demand for such products evaporates as the populace gains a level of wealth and income generation due to the fact that better and more costly alternatives are now within reach. However, these goods never entirely dry up or go away unless they become technologically obsolete due to the fact that there remains a distinct layer of society that will always exhibit some proclivity to demand for such products. A. Coefficient explanations: Elasticity coefficient is a value that is used to indicate the percentage change that will occur in one variable, as a result of a change in the other variable. Coefficient of elasticity of demand: This refers to the value given by the comparison of the percentage change in the quantity demanded to the percentage change in the price of a commodity. Thus: Coefficient of elasticity of demand=% change in quantity/% change in price This coefficient can result to the demand being either elastic, unit elastic or inelastic. Elastic Coefficient of elasticity of demand occurs when the percentage change in quantity demanded is higher compared to the percentage change in the price of the commodity. Elastic Coefficient of elasticity of demand: % change in quantity/% change in price =< - 1, which indicates a positive response of the people to the change in prices of a commodity. Elastic Coefficient of elasticity of demand occurs when the percentage change in quantity demanded is less compared to the percentage change in the price of the commodity. Inelastic Coefficient of elasticity of demand: % change in quantity/% change in price = > - 1, which indicates a negative response of the people to the change in prices of a commodity Elastic Coefficient of elasticity of demand occurs when the percentage change in quantity demanded is equal to the percentage change in the price of the commodity. Unit elastic Coefficient of elasticity of demand: % change in quantity/% change in price = - 1 Coefficient of Cross-price elasticity: This refers to the value given by the comparison of the percentage change in the quantity demanded to the percentage change in the price of a commodity. Coefficient of Cross-price elasticity=% change in quantity of product A/% change in quantity of product B Coefficient of income elasticity: This refers to the value given the percentage change in demand of goods, compared to the percentage change in income of individuals. Coefficient of elasticity of demand=% change in demand of goods /% change in income. B. Contrast of Terms The contrast existing between Elasticity of demand, Cross-price elasticity and Income elasticity is that: Elasticity of demand establishes how the change in the price of a commodity will affect its demand, Cross-price elasticity establishes how the change in the price of one commodity will influence the demand of a different commodity, whether a substitute or a complementary good, while Income elasticity establishes the influence that an increase or decrease in the income of individuals affect the demand of certain goods, whether normal, superior or inferior goods. Significance of differences The significance of the differences is that they allow an individual to understand how different forces such as income, complementary and supplementary goods, as well as the change in the price of goods affects the demand of goods by the consumers, and thus ultimately alters the markets equilibrium. D. Whether demand would tend to be more or less elastic for each of the following Availability of substitutes The availability of substitutes will make the demand more elastic, since individuals will have a large variety from which to choose from. When there are very few or no substitutes, the elasticity of demand will tend to be inelastic, since the consumers do not have much of a choice. Share of consumer income devoted to a good The share of income that is devoted to a good will tend to make the demand of a commodity less elastic, since the demand is restricted to operate within the boundaries of the income share allocation. This tends to make the demand less elastic since the buyer cannot flex the purchase beyond the limits of the income. Consumer’s time horizon Consumer’s time horizon has the effect of making the elasticity of demand more elastic, since the more time the consumer has, the more they are able to look for alternative products, making the demand more elastic. However, when the Consumer’s time horizon is limited, the demand becomes less elastic, since the consumers are short of time to compare alternative products and make decisions, thus tend to purchase the commodity that is readily available. This makes the elasticity of demand less. E. Example for each of the three determinants Availability of substitutes: The availability of substitute products to coffee, such as tea and cocoa makes the demand more elastic, since individuals who find coffee more expensive can opt for tea or cocoa. Share of consumer income devoted to a good If a consumer devotes 10% of his income to purchasing cloths every month, the demand for clothing is limited to a maximum of 10% of the income, making that demand less flexible and thus less elastic. Consumer’s time horizon If the consumer has a whole day of doing shopping, he/she will have time to compare products and their prices before deciding on what to purchase. This makes the demand for such commodities more elastic. However, if the consumer has only 1 hour to do the shopping, he/she will settle on the product that he comes across first, thus limiting the elasticity of demand. F. Differentiate between perfectly inelastic demand and perfectly elastic demand Perfectly inelastic demand means that a consumer will still buy a commodity regardless of the changes in prices. On the other hand, perfectly elastic means that a consumer will not purchase a commodity, if the price moves at all. Using the attached “Graphs for Elasticity of Demand and Total Revenue”; perfectly inelastic demand is at quantity 4.5, while perfectly elastic demand is at total revenue 200. Perfectly Elastic vs. Perfectly Inelastic Demand is illustrated in below graphs 1 and 2. Graph 1 illustrates a perfectly elastic demand curve whereas graph 2 represents a perfectly inelastic demand curve. Graph 1 Source: Falberg, 2011 Graph 2 Source: Falberg, 2011 G. Relationship between elasticity of demand and total revenue One can understand the relationship between elasticity of demand and total revenue to be one in which, if demand is inelastic, any subsequent increase in price will lead to an increase in total revenue. Similarly, if demand is found to be elastic, an increase in total price will translate to a decrease in total revenue. In much the same way elastic range refers to the flex zone in which demand is likely to move within as a function of the consumer need, desire, or whim. Similarly, inelastic range refers to the region of demand that is ultimately unaffected by the consumer taste, need, or desire. In a similar corollary, unit elastic range is an elastic range that is specific to a particular unit of a particular good or service. As such, the unit elastic range is more likely to be bound directly to determinant market forces than one which is not. Lastly, Unit Elastic Price ultimately refers to a supply and demand situation which is perfectly responsive to changes in price. Using the attached “Graphs for Elasticity of Demand, Total Revenue”: Elastic range: the elastic range occurs between prices 40 to 80 and quantity 4.5-9. Inelastic range: The elastic range occurs between price 0 to40 and quantity 0-4.5. Unit elastic range: the unit elastic range occurs at price 20 and quantity 4.5. References Arak, M., & Spiro, A. (1973). A theoretical explanation of the interest inelasticity of money demand. Review of Economics & Statistics, 55(4), 520. Chai, A., & Moneta, A. (2010). Retrospectives: Engel Curves. Journal of Economic Perspectives, 24(1), 225-240. doi:10.1257/jep.24.1.225. Falberg, W. (2011, January 12). Inelastic demand and the invariable cruddiness of liquor stores. Transitive Blog — Another foot soldier in the army of cranks and heretics. Retrieved January 29, 2013, from http://www.voraciousrationalist.com/2011/04/inelastic-demand-and-the-invariable-cruddiness-of-liquor-stores/. Khan, M. (2012, October 23). Normal and inferior goods. Khan Institute. Retrieved January 29, 2013, from https://www.khanacademy.org/science/microeconomics/supply-demand-equilibrium/demand-curve-tutorial/v/normal-and-inferior-goods. Fouquet, R. (2012). Trends in income and price elasticities of transport demand (1850–2010). Energy Policy, 50, 62-71. doi:10.1016/j.enpol.2012.03.001. Marbán, S., van der Zwaan, R., Grigoriev, A., Hiller, B., & Vredeveld, T. (2012). Dynamic pricing problems with elastic demand. Operations Research Letters, 40(3), 175-179. doi:10.1016/j.orl.2012.01.005. Read More