The Concept of Price Elasticity of Demand - Essay Example

The Concept of Price Elasticity of Demand Introduction The term elasticity is used to measure the effect of change of one economic variable affect others. In other words elasticity can be defined to be the ratio of percentage change in one variable to the change in percentage of the other. Elasticity is a tool for taking into account the responsiveness of a function to changes in parameters. The frequent forms of elasticity used by the researchers are price elasticity of demand, income elasticity of demand and the cross price elasticity. Price elasticity of demand The term price elasticity of demand is used to show the responsiveness or the change in demand conditions due to change in the price level of goods and services in an economy. Price elasticity of demand provides the measurement of percentage change in demanded to one percent change in prices. The sign of price elasticity is more frequently than not “negative although analysts tend to ignore the sign as it can lead to ambiguity”. However, positive price elasticity of demand can be achieved for Giffen goods or goods that “do not conform to the Law of Demand”. A less than one value of price elasticity of demand value implies inelasticity of a good i.e. change in the price conditions seems to have small effect on the quantity demanded of that good (Marquez, 2002, p. 22). The demand for a good is said to be elastic when the value of price elasticity is greater than one which small changes in the price level will have significant effects on the quantity demanded of that good. Revenue can be “maximized when the value of price elasticity of demand is equal to one”. The formula for the price elasticity of demand is provided below: The inverse nature between price and quantity demanded in case of normal good lead to negative value. (Marquez, 2002, p. 22) Income elasticity of demand The term income elasticity of demand is used to define the change in demand conditions due to change in income of the consumers in an economy keeping other conditions as constant. A negative value of the income elasticity can be achieved in case of inferior goods where a rise in income of the consumers will lead to fall in demand of that good. A positive value of price elasticity of demand can be achieved in case of “normal goods where an increase in income will lead to rise in demand” conditions for that good whereas if the value of income elasticity of a good is less than one implies the good is a necessity good (Flynn and Antonioni, 2011, p. 124). Again “if the elasticity is greater than one then the good can be categorized as luxury or superior good”. In case of sticky goods the value of income elasticity of demand is zero and this implies a “change in income level is not associated with change in demand for that good” under consideration (Flynn and Antonioni, 2011, p. 124). The income elasticity of demand can be utilised as the guide to the firms to make investment decisions. Income elasticity shares close proximity with “population income distribution” and part of the total sales attributable to the buyers from varied income brackets. When a purchaser or consumer belonging to a “certain income bracket experiences a rise in income”, they tend to raise their demand and match with the consumers belonging to higher income brackets. The formula below is that of income elasticity (Flynn and Antonioni, 2011, p. 124). One can think of five possible income demand curves. “High income elasticity of demand occurs when income is accompanied by relatively large increase in the quantity demanded.” Unitary income elasticity of demand occurs when rise in the income level is accompanied by same proportionate rise in demanded quantity whereas low income elasticity of demand occurs when rise in income is accompanied by relatively less than increase in demanded quantity (Grant and Vidlerl, 2003, p. 74). Zero income elasticity of demand occurs when quantity demanded remains unchanged irrespective of change in income. Negative value of income elasticity occurs when “rise in income is accompanied by fall in the quantity demanded”. (Grant and Vidlerl, 2003, p. 74). Cross elasticity The term cross price elasticity is used to define the responsiveness of change in demand for one good due to change in price of another good. The cross price elasticity is measured in percentage terms. A negative value of the cross price elasticity occurs when two involved goods are of complements where as positive cross price elasticity occurs when two goods are substitutes. The formula of cross price elasticity is demonstrated below: Two goods A and B have been taken under consideration in determining the formula for the cross price elasticity. The diagram below shows the analysis of cross price elasticity where the goods taken under consideration are complements in one case and substitutes in the other. Conclusion One of the important concepts that can influence the pricing strategy is price elasticity of demand which shows the change in the quantity demanded of a certain product due to change in the price of the same product. Suppose a selected company reduces the price of one of its products by 10% and the demand of the same product increases by 20% then the price elasticity is 2. The demand curve of the normal goods are said to be elastic. Again if the price of the normal good increases by 10% but if the demand rose by only 5% then the demand curve comes out as inelastic. Another important concept is the income elasticity which is referred to as change in demand of a certain product (normal good in this case) due to changes in the income of the people keeping the other conditions as constant. Elasticity of cross price is measured as the variation in demand for a product (normal good) due to fluctuations in the price of substitutes of that good. Reference list Grant S. and Vidlerl, C., 2003, Heinemann Economics for Edexcel: A2 Student Book, Heinemann Educational Publishers, Scotprint, Shropshire, UK. Flynn S. and Antonioni, P., 2011, Economics For Dummies, UK Edition. John Wiley and Sons Ltd., West Sussex, UK. Marquez, J., 2002, Estimating Trade Elasticities, Springer, UK. Read More