Elasticity of Demand - Essay Example

Elasti of Demand A Definition of terms Elasti of demand The law that governs demand and prices of products shows that the more the price of a commodity falls, the more it is bought. It also holds that the converse is true. The question arises as to how much or less of the commodity whose price is changing will be bought. Elasticity of demand is therefore, a measure of buyers’ response to commodity price changes in the market. 2 Cross-price elasticity This is a measure or an indication of the way demand for a product responds to a change in the prices of related products. The related products whose price change result to the change in the price of the commodity are classified as substitutes and compliments. In substitute goods, for example, cleaning agents, a rise in the price of one product causes an increase in demand for the competing product. For complementary products, the decrease in price of a commodity, for example, computers, will see an increase in demand for software. 3 Income elasticity Also, called Income Elasticity of Demand, this measures the relationship between a change in the quantity of a product demanded and the corresponding income. In this concept, there are inferior and normal goods. Normal goods are those that have positive income elasticity such that as income increases demand of the products increases at each price level. Inferior goods have a negative income elasticity of demand, and this means that their demand falls as income rises. B Explanations for the elasticity coefficients of the terms defined above The coefficient of income elasticity is obtained by dividing the percentage change in quantity demanded for a given good Y by the percentage change in the consumers’ income. For the elasticity of demand, economists measure the degree to which demand is price elastic or inelastic by calculating the pertinent coefficient. This is obtained by dividing the percentage change in quantity demanded of a product X by the percentage change in the price of the same product. Since price changes and quantity almost always move in opposite directions, Economists usually are not interested in putting the minus sign but more on the co-efficient of demanded elasticity. When price elasticity is zero (Ped=0), then demand is perfectly inelastic meaning no change in price will alter the demand of the product. When the elasticity is between 0 and 1(Ped=01), then demand is said to be inelastic meaning that the percentage change in quantity demanded is smaller than the percentage change in price of the same product. A good example of inelastic demand is one for table salt. When the elasticity equals to 1(Ped=1), then the product’s demand is said to be unit elastic, meaning that the percentage change in quantity demanded is the same as the percentage change in price of the same product. When elasticity is greater than 1 (Ped>1), then demand for the product is termed as being elastic. This means that the demand responds more than proportionately to change in price. Example a 25% increase in price on a good might lead to 40% drop in quantity demanded as the elasticity is the -1.6 (Case & Fair, 1999). For the cross-price elasticity, the coefficient which measures the relationship between the related products is calculated by dividing the percentage change in quantity demanded for a good B by the percentage change in price for good X. When this coefficient is greater than zero, the two goods are substitutes and if less than zero, the goods are complements. When it is equal to zero, the two goods are said to be independent and therefore have no relationship. C Contrasting the terms in A The terms defined in above are all related and revolve around the same thing; the relationship between the demand and prices for various products. The elasticity of demand the understanding of the relationship that exists between the demand for a product and the price change put on product. The cross-price elasticity analyses the relationship between related products and how the change in price for a product affects demand for a rival commodity. The third term, income elasticity, determines the relationship between a consumer’s demand for a product and their corresponding income levels. 1 Significance of differences between the terms contrasted above The significance of the various relationships represented by the terms is apparent as they explicitly state what they investigate in the inter-related and interconnected world of business economics. One of the terms exclusively deals with analyzing the relationship between the price changes of commodities and their demand. To distinguish price elasticity from the others we have one product in question where the main components to derive the elasticity are to check the commodity’s price in response to its own quantity demanded. Importance of studying price elasticity is to help know the impact of price changes on a commodity to its quantity demanded as well as help the producers know if they can practice price discrimination on a particular commodity on the different markets they supply. Cross elasticity is unique in that it relates price of commodities with their substitutes and complements. A good example is the demand for DVD players where a fall in price of DVD players will lead to high demand markets for DVD videos as these are complementary goods. Importance of studying cross elasticity of demand helps sellers keep competition healthy. It also helps economists know the substitutes and complements of some goods as where there is a zero cross elasticity means no relation in the compared goods (Ayers & Collinge, 2003). Income elasticity differs from the others as it does not relate to commodity prices but to the level of consumer’s income which is directly proportional to their spending power. The importance of studying the income elasticity is to help grade the best market for certain goods as income in an area, may help guide the demand of some certain goods. This depends on the rating of the goods by consumers either as inferior, necessities, and luxury or normal goods. These differences are critical in helping economists evaluate the degrees of relationships between the variables in question by calculating the required coefficients. D How would elasticity of demand change for each of the following determinants 1 Availability of substitutes Availability of substitutes makes products cheaper as competition sets in and the individual product monopoly is marginalized. This makes elasticity of demand for the product less as people buy less of the product as there are alternatives or substitutes. 2 Share of consumer income devoted to a good A consumer’s share of income devoted to a particular good change with their levels of income. When a consumer’s income level increases, their demand for a particular product may increase or decrease. For example, when someone’s income increases, their purchase for inferior goods decreases, this includes goods such as used clothes and long distance bus tickets. People will tend to buy readymade clothes and get airplane tickets for long travels, thus the demand for goods like used clothes bus tickets will decline. When the demand increases, economists conclude there is a positive elasticity of income demand and when the demand decreases, there is said to be a negative elasticity of demand. Also, if a good takes up a high proportion of the household’s income, then a change in price would lead to an elastic demand than those that take up little from the house budget. For example, daily fueling of a car to travel to work would be negatively affected if there were to be an increase in petrol prices as most workers would prefer to take a bus travel as it may prove cheaper (Case & Fair, 1999). 3 Consumer’s time horizon A consumer’s time horizon is the amount of time that it takes a customer or client to analyze the effects of a commodity price change. This can affect the price elasticity of demand and those commodities which do not have alternatives or substitutes tend to exhibit lower price elasticity of demand. On the other hand those which the consumer can easily find a substitute have a higher price elasticity of demand. However, this is determinant on the time that is available for consumers to decide on the substitutes that they have. For example, increase in Wi-Fi providers in the U.S. has led the price elasticity for Wi-Fi connections, but before consumers decide on the substitute providers they want to take, it will take time for them to weigh the services of other providers in the market. Thus, consumers will continue using Wi-Fi even though the price is raised as they look for other options Examples of the three determinants in D above In the case of availability of substitutes, we can consider a scenario where there is a wide variety of cooking appliances. This makes the demand for an appliance decrease when its price is increased. This is because customers have a wide variety of appliances to choose. When a consumer’s income increases and they had devoted a certain percentage of their income to some product, say cigarettes, the demand for the product may fall. The consumer can choose from a wider range of products which are related to cigarettes not consume cigarettes as before. The logical impacts that may influence business decision making include the need for a business to maintain reasonable commodity prices where there are substitutes. In some cases, the businesses that sell certain commodities which are affected by changes in income can do nothing about the changes in demand. They can only focus on cutting production to minimize on waste. E Differences between perfectly inelastic demand and perfectly elastic demand. Perfectly inelastic demand refers to a situation where a price increase has no change in quantity demanded. This implies that the coefficient of the price elasticity of demand is zero as the graph obtained of price change versus quantity demanded has no gradient, that is, there is no change in the quantity that is demanded. Perfectly elastic demand refers to the scenario where the increase in a commodity’s price causes a change in demand from infinite to zero. The price-quantity graph for this type of demand is a horizontal line whose gradient is infinite. F Relationship between elasticity of demand and total revenue for the following ranges along the demand curve 1 Elastic range In the elastic range of demand, a decrease in price of a commodity will cause an increase in total revenue. This is because more additional units get to be sold due to higher demand and compensate for the lower price. In the above graph, a decrease in price leads to an increase in revenue. When the price of a commodity is $2, total revenue is 10. However, when price is $1, total revenue is increased to 40, which is higher than 10. The elastic demand curve shows that a small change in price results to a more than proportional change in quantity demanded. 2 Inelastic range. When demand is inelastic, a decrease has the effect of reducing total revenue. This is because the decline per unit’s value cannot be offset by increased sales and the total revenue consequently tumbles. In the graph above, the change in prices has a relatively reduced change in the quantity demanded. When price of a commodity is $4, the quantity demanded is 10 with total revenue of 40. However, when price falls to $1, the total revenue is 20, lower than 40. This situation is applicable in the case of businessmen with air travel. Due to the importance that they attach to their business and the urgency that is sometimes associated with it, they have no choice but to travel. This is despite the price that the airlines may be charging. Their demand does not change with changing prices, thus inelastic demand. 3. Unit-elastic range This is a special case as the total revenue remains unchanged when there is a change in price. The increased sales offset the reduced unit value when price is reduced. When a products’ price is increased, the reduced sales offset the revenue gained from the increased unit’s value. 0 10 20 30 Q Unit elastic In the graph above, the change in prices does not have any impact on the quantity of goods demanded, an increase in price may affect sales but this is rectified by a consequent decrease in price that ultimately increases sales to their normal rate, hence total revenue does not change. References Ayers, R. M. & Collinge, R. A. (2003). Microeconomics: Explore & Apply (New Edition). New Jersey: Pearson-Prentice Hall. Case, E. K. & Fair, C. R., (1999). Principles of Economics (5th ed.) New Jersey: Prentice-Hall. Read More