Price Elasticity of Demand - Term Paper Example

Price Elasticity of Demand Price elasticity of demand measures the change in quantity demanded with changes in the price. As evident from the formula given above price elasticity of demand is calculated using percentage changes in quantity demanded and price. This is because elasticity is independent of the type of measure used. Also, average values for quantity and price are used so as to eliminate discrepancies arising due to movement from lower to higher or from higher to lower price. (For example going from 7 to 10 is a 30% change while going from 10 to 7 is a 42.86% change). First let us look at the formula of price elasticity of demand: Formula = % Change in Quantity / % Change in Price           % Change in Quantity = (Q2 - Q1) / [(Q1 + Q2) / 2]           % Change in Price = (P2 - P1) / [(P1 + P2) / 2] where,         Q1 = Initial quantity         Q2 = Final quantity         P1 = Initial price         P2 = Final price Now let us consider the different range of values of price elasticity of demand. Elasticity = 1 When elasticity is equal to one it is called unit elasticity and the change in quantity demanded causes a proportionate change in price. So a price change in either direction will not yield a change in revenue. Elasticity > 1 When elasticity is greater than 1 the quantity demanded changes to a greater degree than the change in price. The demand curve aligns increasingly aligns itself to the x- axis in the case of near infinite elasticity, meaning than the quantity demanded is particularly responsive to changes in price. This case is also known as being perfectly elastic and is shown in the graph below: Perfectly Elastic Demand Curve From this demand curve it is evident that an extremely minute change in price would lead to an infinitely large change in quantity demanded. This scenario can be applied to perfectly competitive markets or luxury items. Elasticity < 1 When elasticity is less than one the quantity demanded responds insignificantly to changes in price. Increase the price would increase revenue, and vice versa. As the elasticity approaches 0, the demand curve becomes parallel to the y-axis. So the quantity demanded becomes more or less independent of price. This is known as being perfectly inelastic demand. Perfectly Inelastic Demand Curve The graph shows that changes in price would have no impact on quantity demanded. This can be applied to products such as fuel, drugs e.t.c. Factors Influencing the Price Elasticity of Demand Degree of necessity or luxury - Luxury products usually have greater elasticity of demand. Availability of substitutes - The higher the number of alternate products available (substitutes), the greater the elasticity. Time period - Over the long run elasticity tends to be greater since the customers adjust to price changes. Psychological pricing – Price changes such as reduction from $10 to $9.9 results in proportionately greater increase in quantity demanded than reduction from $9.9 to $9.8 Nature of price change – Whether the price change is permanent or temporary Integration Integration is concept of supply chain management that origins from microeconomics. The basic idea is to partner or collaborate with all the stakeholders relevant to the production of goods and services offered by an organization. There are several ways of doing so; we will look at each in detail along with its advantages and disadvantages. Horizontal Integration In horizontal integration an organization merges with its competitor(s) that produce similar products. Advantages – The basic advantage of horizontal integration is that it may provide economies of scale. Increased distribution capacity and market access is also possible, leading to greater market share. Disadvantage – the major disadvantage is that since horizontal Integration restricts competition it might lead to creation of conglomerates or even monopolies. This in turn can be harmful to the interests of end-consumers. Vertical Integration This can be done by an organization integrating with its suppliers either through acquisitions or mergers of supplier(s) (upstream) or purchasing various distribution channels (downstream) Downstream Advantages - Quality standards can be ensured till the deliverance of goods or services. Upstream Advantages - Reduces inventory costs (concepts such as Just-in –Time inventory can be applied), and the quality and standard of raw materials can be monitored and maintained. Overall vertical integration can result in more efficient business operations reduced costs and higher profits. Conglomerate A conglomerate can be termed as a multi-industry organization whose sub-divisions or companies usually belong to different sectors or entirely different industries.       1. Advantages - Such integration can provide stability in sales and revenue and greater financial leverage and ease of access to capital for expansion. Also, different businesses can compliment each other and conglomerate mergers can provide immediate production facilities, skilled management and pre-established vendors and distribution channels.        2. Disadvantages – Conglomerates though very popular in the post world war era are becoming less common. Conglomerates are similar to the concept of Jack-of-all-trades which by current management practices is not considered a good practice. The world today is moving towards specialization. Letting everybody do what they can do best and focus on areas of expertise. This is not to say that conglomerates do not exist today. Synergy The basic purpose for which an organization integrates is to benefit from increased value. Essentially the benefit of increased organizational value due to integration should outweigh the sum of values for individual entities (with which integration is done). This is the basic concept of synergy. There are six basic synergies: Greater Revenues Costs Decrease – The concept of economies of scale (horizontal integration).Also the overhead may be spread over more units. Quality Assurance - Easier to maintain a certain level of quality (vertical integration) Capitalization Advantages: If the P/E ratio of the buyer exceeds that of the target acquired, there will be an immediate market gain. Inflation Inflation as defined by Parkin and Bade “is an upward movement in the average level of prices. Its opposite is deflation, a downward movement in the average level of prices. The boundary between inflation and deflation is price stability”. An observable fact is that the value of currency does not remain the same over a period of time. This is mainly due to inflation, these changes also change the purchasing power of currency (how much can unit currency buy). Rising inflation decreases purchasing power and vice versa. For example if the inflation rate of a country is 10%/annum then a McDonald’s Burger costing $10 will cost $11 after one year. Causes of Inflation Even though there is no agreed single reason that can be identified as the cause of inflation but there are two general categories into which inflation can be classified based upon the causes. Demand-Pull Inflation – The popular notion of "too much money chasing too few goods" is usually used to describe this type. What happens is that the demand outpaces the supply, and due to the simple mechanism of demand-supply the prices increase. This is a usual and frequent occurrence in many countries especially developing economies.  Cost-Push Inflation – Cost push inflation occurs when firms increase their prices to cope with the rising cost of production and maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports. There are several types inflation: Deflation – This is the opposite of inflation and occurs when general level of prices is falling. Hyperinflation – This is an unusual case where there is unprecedented rise in inflation rates (sort of phenomenal inflation rate). There is nothing good about hyperinflation and it leads to the economic collapse of a country. Stagflation – This is a combination of economic stagnation, high unemployment along with inflation. The phenomena occurred during 70’s in industrialized countries, which had a stagnant economy combined with rising oil prices. Built-in inflation – This type of inflation is stimulated by expectations (the concept of price/wage spiral). It involves salaried/wage employees trying to keep their wages at par with prices and then firms pass the higher sales costs on to consumers. Effects of Inflation on the economy Redistribution Inflation redistributes income from people who depend on fixed incomes, such as pensioners, to those whose income is variable such as from wages and profits which may keep pace with inflation. It also redistributes wealth from creditors to debtors. For debtors it is analogous to obtaining an interest free loan. If inflation rate is higher than other countries, then a fixed exchange rate will be undermine and lead to weakening balance of trade. If the inflation rate is greater than that of other countries, domestic products become less competitive Increasing uncertainty may discourage investment and saving. Fiscal drag occurs when more and more people start falling into higher tax brackets due to rising inflation and stagnant tax bracket rates. By doing so governments in effect allow tax increase (hidden tax). Governments, Inflation and Remedies There are a number of methods that are used by governments to control inflation. The Central bank of any country is the one usually responsible for controlling inflation by managing interest rates and other monetary polices. The most utilized method is that of high interest rates and slow growth of the money supply. Keynesian economists suggest reducing demand in general, often through both fiscal and monetary policy, increased taxation or reduced government spending. All of these policies are open market operations. Another method is the wage-price control ("income policies") in combination with rationing. This policy has been effective especially during times of war. But wage-price policy is a last resort measure and can only be effective when coupled with policies to reduce the underlying causes of inflation during the wage and price control regime. The general approach would be to liberalize prices by assuming that the economy will adjust according to the laws of the free market activity. This will lead to an overall fall in the total economic output of the country and usually causes a severe recession where the productive capacity is reallocated, after which the economy is reborn and becomes stable. (Abel & Bernanke, 291) Supply-side economics Supply side economics was a school of thought championed by republican president Ronald Reagan. It pursued a macroeconomic policy aimed towards long-run economic growth rather than business-cycle management. The budget policy of the era focused on: Bolstering defense Reducing civilian programs Little weight age given to fiscal deficits A program was launched to reduce the burden of federal regulations Lowering of taxes and tad tax burdens The first theme of supply side economics was the major role played by incentives, particularly adequate returns to working, saving and entrepreneurship. The other strand of supply side economics was its advocacy of large tax cuts. The argument was that demand-side impacts were over-emphasized. According to supply side economics high taxes lead people to reduce their labor and capital supply, so much so that it was purported that higher taxes might actually lower tax revenues. The philosophy underlying supply side tax cuts was that the reforms should improve incentives by lowering tax rates on the last dollar of income (marginal tax rates), the tax system should be progressive (lowering tax burden on high-income individuals) and that the system should be designed to encourage productivity and supply rather than to manage aggregate demand (which is the dominant Keynesian view). The idea was that a decline in tax avoidance and increase in business activities would permit lower rates with little or no loss of revenues in the top tax brackets. Most economists thought that tax changes influenced output and revenue primarily by changing the demand for goods and services. But research and the tax policy changes of the eighties, indicate that supply-side incentive effects are quite important. (Victor et al., 213) Critical to the operation of supply-side economic theory was the development of free trade and free movement of capital. The argument was that free capital movement, in addition to the classical reasoning of comparative advantage, frequently allows economic growth. Some supply-side economists advocated that monetary policy should be based upon price rule. The monetary policy should target a specific value of money irrespective of the quantity of money that must be created or withdrawn by the central bank to achieve the target so the assumption was that the value of money is purely dictated by the supply and demand for money. (Samuelson & Nordhaus, 337) References: Andrew B. Abel, Ben S. Bernanke. Macroeconomics (Fourth edition). 2003 Canto, Victor A., Douglas H. Joines, and Arthur B. Laffer. Foundations of Supply-Side Economics. 1983. Parkin and Bade. Essential Foundations of Economics Economics, 2003 Samuelson & Nordhaus. Economics (Seventeenth edition). Mcgraw Hill, 2001 Read More