Types of Elasticity of Demand and Its Importance - Essay Example

?Types of Elasti of Demand and Its Importance Price elasti of demand is the measure of responsiveness of the quantity demanded with respect to changes in price. It measures how much variation would a price change cause in the market. The formula for calculating Price Elasticity of Demand is Percentage Change in Quantity demanded divided by Percentage change in Price. If the result if this formula is less than 1, the demand is known to be Price Inelastic. And vice versa, if the resultant is more than 1, this would mean that the demand is Price Elastic (Boyes et al, 2008). For example, in the following demand schedule, a change in price from ?8 to ?10 causes a fall in demand from 1500 units to 1000 units. Price (?) Quantity 6 1800 8 1500 10 1000 The Price Elasticity of Demand for the above Demand Schedule would be as follows: PED= % Change in Quantity Demanded (Boyes et al, 2008). % Change in Price = [(1500 – 1000)/1500] * 100 [(?10 - ?8)/8] * 100 =33.3% 25% = 1.33 This shows that the demand for given product is price elastic i.e., small change in price would bring about greater changes in the quantity demand. Some factors which effect the elasticity of demand are the availability of close substitutes in the market, consumer preferences and the degree of necessity a product carries (Boyes et al, 2008). Price Elasticity of Supply measures the resposiveness of Quantity Supplied by the producers with respect to changes in prices. Similar to the concept of Price Elasticity of Demand, if the outcome is less than 1, the supply is said to be price inelastics and if the resultant is greater than 1, the supply is considered as Price Elastic (Boyes et al, 2008). The formula for calculating Price Elasticity of Supply is as follows: PES= % Change in Quantity Supplied (Boyes et al, 2008). % Change in Price For example, given below is a model supply schedule which will be used to measure PES when the price changes from ?7 to ?10. Price (?) Quantity 5 1000 7 1300 10 1500 PED= % Change in Quantity Supplied (Boyes et al, 2008). % Change in Price = [(1500 – 1300)/1300] * 100 [(?10 - ?7)/7] * 100 =15.4% 42.8% = 0.36 The number suggests that the supply for the given Supply Schedule is Price Inelastic i.e., the quantity supplied is not as responsive with respect to price changes. There are some factors which effect the elasticity of supply one of which is the ease availability of resources (Boyes et al, 2008). Cross Elasticity of Demand (XED) measures the responsiveness of quantity demanded of Good A with reference to price changes in Good B. Cross Elasticity is used to measure the degree of substitution between the two products i.e., how close the two goods are substitutes to each other. Again, if the Cross Elasticity Demand of Good A and B is elastic or of a greater value, the products would be close substitutes. A small change in the price of Good B would bring about greater changes in the demand for Good A and vice versa (Mushin, 2000). The formula for Calculating XED is: XED= % Change in Quantity Demanded of Good A (Boyes et al, 2008). % Change in Price of Good B XED= % Change in Quantity Demanded of Good A (Boyes et al, 2008). % Change in Price of Good B = [(1750 – 1500)/1500] * 100 [(?11 - ?10)/10] * 100 =16.6% 10% = 0.6 If Sunsilk and Pantene are taken into consideration, if the Price of Pantene changes by 10%, the demand for Sunsilk would change by more than 10%. This would give a comparatively higher value of XED and hence it can be deduced that Sunsilk and Pantene are close substitutes (Boyes et al, 2008; Mushin, 2000). Income Elasticity of demand is used to measure the nature of the product. If the demand of a product falls when people ‘s income rise, the product would be called an inferior good. In contrast, if the demand of a product rises with people’s income, the product would be called a normal good and vice versa, if the demand of a product falls when people’s income decrease, the product would be called a superior good (Boyes et al, 2008). The formula to calculate this is as follows: YED = % Change in Quantity Demanded (Boyes et al, 2008). % Change in Income The method of calculation is the same as other elasticity of demand. Only the Price section has to be replaced with changes income, which would be [(New income – the Old income)/Old income] * 100 (Boyes et al, 2008). In order to maximize the revenues, firms must have the knowledge about the Income and Price Elasticity of their product. This is because when would plan to raise or reduce their prices to leverage their revenues, this might not prove to be fruitful it unless it is done strategically. If the demand for a product is price elastic, a rise in price would drive the consumers away as the demand would be more responsive to price changes and the consumers are bound to switch to cheaper substitutes. Secondly, if the prices are decreased and if the demand is price inelastic, the firm’s revenue would fall as there would be little reaction from the consumers. If high prices are set for price elastic goods, and low prices are set for price inelastic goods, the revenues would fall. Therefore firms need to know the products’ price elasticity so that it can accurately price its products in order to maximize its revenues (Depken, 2006). On the other hand, pricing strategies have to be set in accordance with the product’s Income elasticity of demand. If a rise in mass market’s income leads to a fall in demand, the product would have to be repositioned as a superior good pertaining to the profitability and would have to high priced for revenues to rise. Moreover, the target market’s purchasing power would have to be gauged in order to determine whether their income changes would affect the demand for the product or not (Depken, 2006). Below Is the diagram of a Bread, a necessity which has in Inelastic Demand and it illustrates the changes in revenue a bread producing firm would experience with respect to price changes (Hubbard et al, 2000). The demand curve shows that the demand for the product is price inelastic. The revenue change from price ?6 to ?8 would be as follows: Old Revenue = Quantity Demanded x Price = 64 x ?6 = ?384 New Revenue (Higher Price) = Quantity Demanded x Price = 56 x ?8 = ?448 As the demand for bread is Price Inelastic, i.e a change in price would bring about a weak response in the Quantity Demanded, firms can actually increase their revenue when prices are increased. This is because being a necessity, consumers would not respond much if the prices are increased (Miller et al, 2009). In the above example, if the prices are raised from ?6 to ?8, more revenue can be generated. In contrast, if the price falls when the demand is price inelastic, the firms would experience a fall in their revenue (Miller et al, 2009). The example below illustrates this situation. Old Revenue = Quantity Demanded x Price = 68 x ?5 = ?340 New Revenue (Lower Prices) = Quantity Demanded x Price = 72 x ?4 = ?288 This shows that when the demand for the product is price inelastic, the revenue would fall on the contrary if firms reduce their prices in an attempt to attract more consumers. As the demand is price inelastic, it is less responsive to price changes and firms would actually lose on revenue if they reduce prices (Depken, 2006). However, if the Demand for a product is price elastic, such as an example of expensive clothing, firms would actually experience a fall in the revenue if it tries to increase its price. This is because with close cheaper substitutes in the market, the consumers would switch away from expensive items to cheaper clothing available in malls and retail outlets (Depken, 2006). The above diagram depicts a Price elastic Demand curve (Hubbard et al, 2000). In this scenario, if the firms try to increase their prices, the consumers would switch to cheaper alternates. This is because they are more responsive to price changes. The effect on revenue is demonstrated below. Old Revenue = Quantity Demanded x Price = 130 x ?6 = ?780 New Revenue (Higher Price)= Quantity Demanded x Price = 89 x ?8 = ?712 The above results show that firms would actually reduce their revenues if they try to increase the prices of their product. On the other hand, if the prices were to be reduced (in forms of Seasonal Sale) when the demand for the firms’ product was price elastic, the following outcome would be seen. Old Revenue = Quantity Demanded x Price = 160 x ?5 = ?800 New Revenue (Lower Prices) = Quantity Demanded x Price = 220 x ?4 = ?880 The revenue would rise if the firms reduce their prices as now, the consumers would switch to the product from other alternatives as it would be cheap. Therefore, the revenue figures would respond differently in accordance with price changes in inelastic and elastic price elasticity. The above facts point out to the importance of Elasticity of Demand in planning pricing strategies for a product. It this knowledge is not known by the producers, then the product would lose a great deal on Revenues if the prices of product whose demand is price inelastic are kept lower unknowingly. Similarly, if the prices are set too high for products which have a highly elastic demand, the consumers would switch away to substitutes and the producers would not know what pricing to follow in order to attract and keep the consumers and make high revenues (Depken, 2006). References Top of Form BOYES, W. J., & MELVIN, M. (2008). Microeconomics. Boston, Houghton Mifflin. DEPKEN, C. A. (2006). Microeconomics demystified. New York, McGraw-Hill. http://www.netlibrary.com/urlapi.asp?action=summary&v=1&bookid=138909 HUBBARD, R. G., & O'BRIEN, A. P. (2006).Microeconomics. Upper Saddle River, N.J., Pearson Prentice Hall. MILLER, F. P., VANDOME, A. F., & MCBREWSTER, J. (2009). Monopolistic competition. Beau Bassin, Mauritius, Alphascript Pub. MUSHIN, J. (2000). A Forum for Ideas: Co-Existing Prices and Cross-Elasticity of Demand. Kyklos. 53, 71-74. . Read More