Price Elasticity of Demand - Essay Example

Economic Analysis al Affiliation         PART Elasti Elasti is the degree of responsiveness in supply and demand within a market in relation to price changes (Nicholson & Snyder, 2012). Elasticity value which is greater than one indicates that the demand for good is affected significantly by the price. It is measured as the mathematical ratio of the percentage of change when assessing impact of the variables upon the other (Frank 2014). The elasticity of demand is used in determining the volume of sales which will be reached when a price changes. Price elasticity of demand This is refers to the price sensitivity to the demand of a product. It is expressed as a percentage change in the quantity of a product demanded as a result of a small change in price. In reality, the price elasticity for demand is affected by many other factors other than just the price of commodity. When making calculations, it is normally assumed that all the other factors which could affect PED remain constant. High price elasticity means that the demand for the product is extremely sensitive to changes in commodity price. A zero measure shows that the demand is inelastic and thus will not be affected by changes in pricing. When the value is one, it shows that the demand is perfectly elastic and thus a pricing change will result to an equal change in demand. When the elastic is more than one, it implies that the demand is elastic and when the pricing is changed, it will automatically result in change in the demand from the item as wrong as all the another factors are kept constant. Cross-price elasticity for demand The cross-price elasticity measures the responsiveness of a product demand to changes in price of another commodity. It is measured as a percentage of change observed in the demand for a product as a result of price change of a completely different commodity. It can be used to determine the type of relationship existing between two products (Mankiw 2012). It allows economists to make a distinction between complementary and substitute commodities. Products can be defined as compliments of each other when the calculation of the cross elasticity for demand yields a negative result. When the measure gives a positive value, it is an indication that the products are substitutes of each other. When the calculations yield a zero measure, then there is no relationship between the products (Wetzstein 2013). When a competitor reduces prices of its prices, rival organization will have to consider the calculation of cross-price elasticity of demand in estimating the impact of this price change on the demand for its products. This in turn makes the coefficient important to competitor firms in pricing products which are closely related and can be utilized as substitutes. Income elasticity of demand Frank (2014) states that income elasticity of demand concept is the degree of responsiveness of a commodity’s demand to change upon the income of its consumers. It is calculated as a ratio of the percentage change in demand to the change in income. The coefficient can either be negative or positive based on the existing relationship between a product and income of the consumers of the product. A negative coefficient indicates that the product is inferior and an increase in the income among the consumers will result in the people opting to utilize luxurious substitutes (Frank 2014). A positive value shows that the product is good. Such goods can be categorized into two classes where good with a value less than one is considered necessity good. A value of elasticity more than 1 is considered luxury or superior good. A zero coefficient will occur when goods are considered sticky good whose demand cannot be increased with changes in the income of consumers. Within a normal economic system, inferior goods exist only where superior goods are available. When consumer income rises, the demand for the goods normally reduces because the good become perceived as inferior. The consumers will begin to purchase more expensive substitutes that could be perceived to be products of better quality that the inferior goods. High income elasticity of demand occurs when an increase in the income of consumers results in a relatively larger increase in the quantity of products demanded by the consumers. This is the kind of demand which characterizes luxury goods in the market when utilizing the income elasticity of demand. Unitary income elasticity of demand occurs when the increase in demand is normally accompanied by a similar percentage of increase in the income of consumers of the product. A 10% increase in income attracts a 10% increase in the demand for products, and such is the unitary income elasticity of demand (Mankiw, 2012). PART 2 Practical application of price elasticity of demand The price elasticity of demand is widely used by commercial firms in determine and monitoring the performance of products in the market. Consumers are at times very price sensitive and therefore when the price of a commodity increase, there is a chance that the demand may also reduce. This measure is used by firms whose success is measured in terms of revenue and sales. High price elasticity of demands implies that minimal increase in price will result in increased sales. On the contrary, low price elasticity of demand means that price increase will result in minimal increase in sales. Thus, managers use this measure in determining the appropriate pricing and production strategies with the aim of maximizing the sales and the revenues of the company. A very good example is Proctor and Gamble, which relies on data collected from various stores to determine its product prices. P & G works with large stores such as Walmart to collect data on the effect of pricing on each of the items it manufactures. From the price elasticity demand measures attained, it is able to set out appropriate prices, production levels and price changes in response to seasonal changes in demand of the products. US retailers have used the concept of discounting elastic goods and then holding the inelastic goods at the original process without discount. Such moves by the managers have resulted in good response of the elastic items to promotions. The items register increased sales and consequently bigger profits. On the other hand, not giving discounts on the inelastic items saves the business from making unnecessary money loss. Thus, the concept is useful to managers when determining the best way to increase its sales. Practical application of cross-price elasticity for demand Cross-price elasticity for demand gives the nature and type of relationship which exits between goods in the market. Pricing change of the first commodity or good may result in change in demand of another substitute product. The mobile phone and the technology industry are very much affected by the cross price elasticity of demand. This is because most of the mobile devices and mobile phones act as substitutes to each other. Majority of the phones are capable of carrying out operations done by other devices (Marshalls, 2013). For example, iPhone allows the user to perform various office tasks from their devices. This capability is also found in Blackberry. Thus, the managers must always be aware that an increase in the price for the prices of iPhone will result in an increase in demand for the prices of blackberry phones. This is because the consumers of iPhone will opt to purchase blackberry phones which are substitutes for the iPhone products. The pricing for complementary commodities involves reducing the price of the commodity with a low profit margin in order to increase the demand for another product which has high profit margin (Frank, 2014). If firms can establish reliably, the coefficient of cross-price elasticity for demand for complementary products, they can determine the effects of the pricing. It is used in the development of pricing approaches aimed at ensuring the complementary products produce the desired effects. Popcorns, cinema tickets and soft drinks have a high negative cross-price elasticity which indicates they are strong complements of each other. Reduction in the prices of popcorn and soft drinks can be able to increase the sale of tickets for the cinema. Habitual consumption of a product can decrease the cross-price elasticity coefficient between complimentary products. However, in instances where there is no relationship between the demand of a given item and the changes in price of another item, managers are able to make pricing changes to increase sales without affecting the performance of the product in the market. This has also been witnessed in the mobile phone industry. Such relationship exists between Apple and some mobile phone manufacturers like Nokia. Due to the innovativeness of the iPhone brand, some consumers tend to be less affected by the pricing of the commodity. They put emphasis on the quality and capability of the item. As such, an increase or decrease in price of Nokia may tend to have minimal effect on the demand of iPhone since the costumers are more concerned with the quality of the item. The US telecommunication sector has also witnessed the effect of cross price elasticity of demand. Various service providers such as Verizon and AT & T Inc. are engaged in price wars as they strive to get competitive edge in the dynamic telecommunication sector. Despite Verizon being the leading service provider, in the US market, the reduction in prices made by other service providers like T-Mobile and Sprint Corp have negatively impacted on its performance. This is due to the fact that the measure of the cross price elasticity of demand reveals that the service provided in the sector has a substitutionary relationship. Verizon managers have been forced to respond to the price changes made by the other service providers since failing to do so may have negative impact on its performance and the demand of its services. The managers have always had to consider the complementary and the substitutionary relationship when reducing prices and giving offers. Without this consideration, price alterations may have a detrimental effect on profitability. Practical application of income elasticity of demand This aspect of elasticity relates income changes to demand of products. When the coefficient has been determined to be positive, the commodity can be said to be superior. A negative coefficient on the other hand shows that the items may be inferior. This aspect of elasticity has heavily been used in several industries and sectors by managers to make decisions on the pricing and production of items. Companies which are selling necessity items experience minimal impact of increase in consumer income (Nicholson & Snyder, 2012). The luxury items sector on the other hand is different. In the latter case, an increase of the income among the buyers will require an increase in production to cater for the increasing demand of the items. This is because more people will be able to buy these items. One of the luxury enterprises which use this concept in various managerial decisions is Prada. This Italian luxury hand bag usually carries out market research and analysis to determine the income levels and changes in the market. Since the hand bags are superior in the market, appropriate changes in production levels are made to anticipate increased demand for the handbags when the consumers’ income levels rise. Public managers do benefit from the concept of formulation of the income elastic of demand when making public policies. The residential sector is an example of the other industry which has benefited from it and applied it to come up with public policies and decisions. Frank (2014) states that income elasticity of demand with regard to electricity has for example shown that the measure is very low as compared to the demand in industrial and service sector. Since this is the cases, managers and policy makers are aware that there is no socio-political problem in regard in electricity production when there is no additional investment. Therefore the managers formulate the policies which enhance investments in goods and services sectors where the income elasticity is known to be high.         Reference List Frank, R 2014, Microeconomics and Behavior. McGraw-Hill Education, New York. Mankiw, N 2012, Principles of Microeconomics, 7th ed. Cengage Learning, New York. Marshall, A 2013, Principles of Economics. Palgrave Macmillan, New York. Nicholson, W & Snyder, ‎C 2012, Microeconomic Theory: Basic Principles and Extensions 11th ed. Cengage Learning, New York. Wetzstein, M 2013, Microeconomic Theory: Concepts and Connections. Routledge, London.                 Read More