Supply and Demand: Price Elasticity, Essay Example

Elasticity of demand

Elasticity of demand is the responsiveness measure in the demanded quantity for a good as a result of price change of that given good. It is the percentage change in the quantity a good demanded divided by the percentage change in the price of that good. It gives the percentage demand change that a person might expect as a consequence of one price change. Suppose the quotient less than one, then it is referred to as inelastic; one, unit elastic and greater than one, elastic. When the quotient is infinite, then it is called perfect elastic but when price elasticity is zero then referred to as perfect inelastic (Caldwell, 2003).

Cross-price elasticity

It is the measure of rate of response of demanded quantity for a commodity, as a result of price change of another good. Suppose two commodities are substitutes, it is expected that the consumers will buy more of one good if the substitute’s price rises. On the other hand, suppose the two commodities are complements, rise of price in one commodity should cause fall of demand for both goods. It is the quantity of one commodity divided by the percentage change in price of another good (Kowalski, 2005).

Income elasticity

It is the measure of relationship amid change in demanded quantity for a good and real income change. The percentage change in the quantity demanded of one good divided by the percentage change in buyer’s income. Normal goods are goods in which the demand increases with price increase and decreases for price decrease. For normal goods, price and demanded quantity are directly related. Examples are buying cars, luxuries etc. Demand for inferior goods decreases when the income increases and increases when demand decrease (negatively related). Example is bicycle, when income increases people would tend to buy vehicles and abandon bicycle (Kowalski, 2005).

Question B

Elasticity coefficient of elasticity of demand is the percentage change in quantity of good demanded divided by percentage price change.

When the quotient is one, then it is referred to as unit elasticity coefficient. Suppose the quotient in more than one, it is referred to as elastic and less than then referred to as inelastic.

Elasticity coefficient of Cross-price elasticity is the quantity of one commodity divided by the percentage change in price of another good.

When the coefficient of the cross—elasticity of the demand is negative it indicates that the good type is complementary. For substitutes, however, the coefficient of Cross-price elasticity is positive.

Income elasticity is the percentage change in the quantity demanded of one good divided by the percentage change in income (Morse, 2002).

For normal goods the quotient (E) is positive, and for inferior, E is negative. For normal goods, income increment leads to increase in demanded quantity and so the quotient is always positive. For inferior goods, increase in income leads to decrease in demanded quantity and so quotient is negative (Caldwell, 2003).

Question C

Elasticity of demand only deals with one good, but Cross-price elasticity deals with two commodities. Income elasticity deals with income and quantity demanded. In the case of inferior goods or services, the increase in people’s income lead to decrease in quantity demanded. For normal goods and services, the increase in a person’s income results in a higher demand. For inferior goods, income and quantity demanded are negatively related and so the prices of such good ought to be low for higher income. This means, when people’s income increase, the Companies offering those goods should lower their prices. On the other hand, for normal goods, the change in income leads to increase in demanded quantity, positively related. Their prices thus need to be set high for higher income (Kowalski, 2005). Elasticity of demand helps to detect how quantity demanded changes when price of a given good changes. When the demanded quantity increases, the price should be increased. An elastic demand will rise and fall depending on the price of a good, there will be more demand when the price drops. However, inelastic goods are the total opposite- people will buy the goods no matter what price they may be at. A good example of this would be gas, no matter how high the prices are for gas, and no matter how much people will complain, they will still buy the good at any price, and the demand for this good will never cease. Producers can use price elasticity of demand to predict, thus set prices for their goods. They are able to predict things like the effect of change in prince on total revenue and expenditure on a product, the likely change in price volatility when a market goes through an unexpected change in supply or the changes of a government’s indirect tax.

Cross-price elasticity assists in the comparison of demand of a good suppose the price of another is varied. The other can be substitutes or complements. Cross-price elasticity helps in setting the price a good suppose the prices of other are varied. With cross price elasticity, we make a very important distinction between substitute products and complementary goods and services. With substitute goods, when the price of a rival product will rise, the demand for the same product of a different brand will also go up. When a competitor cuts the price of his product, the rival business can use estimates of cross-price elasticity to predict how this affects the quantity of demand and total revenue on his own product. In the case of complementary goods, you see the demand for products of services which go hand-in-hand rise and fall together. For example, if the price for DVD players goes down, the demand for DVD players will go up, also increasing the demand for DVDs. Businesses who sell DVDs can predict the demand for their goods buy keeping an eye on complementary goods which go with their product.

Income elasticity helps in determining the effects that change in income which would bring to the demand of a good (Morse, 2002). Companies can use income elasticity to predict future consumption patterns and guide firms to investment decisions. When the coefficient is positive, normal goods, when income increases, the goods are to be priced higher. People tend to go for more fashionable, smart good when their incomes increase. Suppose coefficient is negative, it indicates that that particular good becomes inferior when people’s incomes increase because they will opt to buy the more luxurious substitute. Here, increase in income leads to decrease in demanded quantity and so quotient is negative (Caldwell, 2003).

Question D

Availability of substitutes increases the demand elasticity. When there are many substitutes, prices of a given good decreases. And so there would be high percentage change in the quantity a good demanded (increases) and high percentage change in price (price decrease). The elasticity of demand hence becomes negative (inelastic). In other words, the demand elasticity is price and demanded quantity dependent. When the substitutes are many and cheaper, elasticity of the demand increases (Caldwell, 2003).

When a greater share of a person’s income is devoted to a given good, the quantity bought increases and hence its demand (Caldwell, 2003). When demand increases, price increases as well and so percentage change in price and quantity demanded would both increase. The elasticity of demand (% change in demanded quantity divide by % change in price) can attain any value zero to infinite. The business or Companies should be very keen on the good or service that is preferred by many. When they are identified, the prices are easy to determine depending on their demand.

The demand if a good or a service is dependent on the customer’s horizon. In the short run, people may buy more of a certain product despite a price increase. The demand of a product may seem very inelastic when the price right after the price increases. This is because people have not had the time to learn about substitute products and their possible availability. The demand will decrease after some time, and people will start looking for other options. Goods that are used or are to be used in a short duration are demanded more. The service providers after realizing that their services are needed urgently, they raise their prices. When they realize that they would be needed in future, the lower the prices. Customer’s time horizon can be used to set the present prices of goods or services.  When given good would be demanded more in future, their prices are to be lowered awaiting the time (Kowalski, 2005).

Question E

Examples of substitutes of bicycle are; vehicles and motorbikes. When the price of bicycle increase or income increases, most people would go for vehicles and motorbikes (which act as substitutes). If a person devotes one eight of his salary to beverages, and these beverages include regular orange juice and expensive wine, we can look at the orange juice as a low cost good, and the wine a high cost good. The wine would tend to become more elastic as compared to the orange juice. The share portion of a consumer’s income is likely higher for the wine, as compared to the orange juice. This, making the orange juice more elastic than the wine; if subject to price increase. The demand for orange juice, as the cheaper good will be lessened if the price increased by 10%. If wine were to go through the same percentage of increase, it would not suffer the same as orange juice. Orange juice, being already the cheaper good is expected by the consumers to remain at a low cost, thus making it more sensitive when it comes to price change.

With items purchased in the short term, the consumer does not usually consider price drops or significant price changes. For example, if the price for milk immediately increases, the consumer will still buy the milk right after the price increases, and over time look for a substitute brand or lower the demand for milk. The producer for milk will not worry so much about increasing his prices at first, because people will still need to buy their products. Although, by increasing the price of milk, a lot of other goods will have to increase their prices as well, such as bakeries. The producer or seller of milk knows that milk is a hard good to substitute, therefore people will still tend to buy milk even at higher prices for the short-term.

Logical impacts

There are numerous factors that determine the prices of good, among are; customer’s time horizon, availability of substitutes, share of customer’s income devoted to a good among others. Many businesses make decision based on the market status referring to the above mentioned factors among others. When a Company realizes that there are many substitutes for their products, they lower prices of those products. This is to enable them have many customers. Customer’s time horizon also affect decision making in that when a company dealing with less urgent (non-basic) goods always lower the prices to attract clients. If not lowering the prices, they think of ways to make payments for these goods look easier for the consumer. For example, it is a trend now for cars to be available with 0% interest, making the short term horizon of the consumer seem like he is saving money. Commodities purchased in a short time frame always have higher prices due to their necessities. As the example above suggests, in the short run, it may seem that taking a bus to work every day even though the prices rise for fare is cheaper, in the long run, maybe buying a car would help the consumer save money. Many customers customer do devote more of their incomes to essential goods and this creases their demands. Basic things are given priorities over non-basic. A company should make decision on the prices depending on the n umber of people that go for that particular good. When few clients are noted, then the prices should be lowered. However, when prices are to be increased, many factors have to be considered; availability of substitutes, price of complementary goods, demand, necessity among others (Morse, 2002).

Question F

Perfect inelasticity demand is where the price is zero indicating no response to a change in price and therefore a vertical; demand curve.

y-axis- price and x-axis quantiy demanded.

Perfect elastic demand is a case where the price elasticity is infinite; this indicates an infinite response to a change in the price and therefore a horizontal demand curve.

Question G

Total revenue and elasticity of demand are positively related. When the revenue is high, the elasticity of demand is also high and vice versa. When there is a decrease in price, the demand of a commodity increases. In inelastic range, the quantity demanded decreases while the price increases. In unit elastic, the change in quantity demanded equals the change in price. In elastic, the change in demanded quantity is more than the change in price (Caldwell, 2003). From the graphs, elastic range occurs from $80 to $50 price; quantity demanded from 1 to 4; and total revenue from 80 to 200.  Inelastic range occurs from $0 to $40 price; 5 to 9 demanded quantity; from 200 to 0 revenue. Unit-elastic range occurs from $40 to $50 price; 4 to 5 demanded quantity and revenue of 200.

References

Caldwell, E. (2003). Supply and Demand: Price elasticity. Connecticut, USA: Engage Learning.

Morse, M. (2002). Demand and Supply: Thousand Oaks, California: SAGE Publications, Inc.

Kowalski, M. (2005).  Textbook of basic Economics. New York, USA: Lippincott Williams & Wilkins.