Elasticity Of Demand Analysis Essay Example
Elasticity Of Demand Analysis Essay Example

Elasticity Of Demand Analysis Essay Example

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  • Pages: 11 (2807 words)
  • Published: October 12, 2018
  • Type: Research Paper
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The concept of Elasticity of Demand, as defined by Moffat (2010), refers to the responsiveness of demand for a product or service to changes in price. Similarly, Cross-price elasticity quantifies the proportional change in demand for one item when there is a price change in another item, according to Moffat (2010). If two items are substitutes, their cross-price elasticity is 'positive', indicating that an increase in the price of one item will lead to an increase in demand for the other item. Conversely, if two items are complementary, their cross-price elasticity is 'negative', meaning that an increase in the price of one item will result in a decrease in demand for the other item. In contrast, Income Elasticity of Demand measures how responsive quantity demanded is to changes in consumer income.

(Moffat 2010) Normal goods are goods whose demand increases with the rise i

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n the consumer’s income at each price level. They have a positive income elasticity of demand. Normal necessities and normal luxuries are two categories of normal goods, both with a positive coefficient of income elasticity. The income elasticity of demand for normal goods falls between 0 and +1. Demand for these goods increases as the consumer’s income increases, but not as much as proportionately. This is often because necessary goods have a limited requirement for additional consumption as the consumer’s real living standards improve. Examples of normal goods include newspaper, toothpaste, and fresh vegetables.

The demand for goods is not greatly affected by changes in consumer income and overall market demand remains relatively stable. In contrast, normal luxury goods have a demand elasticity greater than +1, meaning that the demand for these goods increase

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at a faster rate than the increase in consumer income. Luxury goods are not essential and can be foregone when income levels are below average or consumer confidence is low. However, when incomes are consistently rising and consumers have confidence in continued growth, the demand for luxury goods will continue to increase. On the other hand, during a recession or economic slowdown, spending on luxury items is typically reduced as consumers prioritize saving and limit their expenditures. Some luxury goods are considered "positional goods."

Consumers obtain satisfaction and benefit from products, both by consuming them and by being recognized as consumers. The demand for lower-quality goods decreases as income rises because of their negative income elasticity. However, during an economic downturn, the demand for inferior goods may actually rise depending on the change in income and the absolute coefficient of income elasticity. For instance, if the income elasticity of demand for cigarettes is -0.4, a 6% decrease in consumers' average real incomes could result in a 2.4% reduction in overall cigarette demand without any other alterations occurring.

In part A, the elasticity coefficients for each of the three terms are explained.

Elasticity of Demand coefficient

The concept of elasticity involves measuring responsiveness, which is represented by numbers or elasticity coefficients. "Responsiveness" indicates that there is a reaction due to a change or stimulus. In this case, a specific change or stimulus has caused consumers to alter their behavior. The elasticity coefficient quantifies the degree to which consumers react.

Businessdictionary.com (2010) defines the coefficient of price elasticity of demand as a measure that assesses how individuals respond to price changes when purchasing products. To calculate this measure, one divides the percentage

change in quantity demanded by the percentage change in price. In simpler terms, elasticity represents the proportional change in quantity divided by the proportional change in price.

If the price increases by 10% and consumers decrease their purchases by 20%, the coefficient becomes -2 due to the negative value resulting from the price increase (a positive number) causing a decrease in buying (a negative number). Economists generally overlook the negative sign and attribute it to the law of demand. A coefficient of 2 indicates a high level of responsiveness to a price change. Conversely, if there is a 10% change in price which leads to a 5% change in sales demand, then the elasticity coefficient is equal to 1/2, indicating an inelastic demand.

According to Amosweb (2010), if the elasticity coefficient is less than one, it is considered as inelastic. If the coefficient exceeds one, economists classify the demand differently. When two goods are substitutes, the cross elasticity of demand will be positive or greater than zero (0). This means that if the price of one good increases, there will also be an increase in demand for the other good. For example, if carbonated soft drink prices rise, there will be a corresponding increase in demand for non-carbonated soft drinks.In cases where products are perfect substitutes ,the cross elasticity of demand equals positive infinity.

(Ingrimayne 2010) When two goods are independent, the cross elasticity of demand is zero, meaning that a change in the price of one good will not affect the demand for the other product. Goods with fewer substitutes generally have a smaller coefficient of demand elasticity compared to products with many substitutes. Broadly defined goods

tend to have a smaller elasticity coefficient than narrowly defined products. For example, the price elasticity of demand for meat is lower than that of pork, and the price elasticity for soft drinks is less elastic than that of colas, which in turn is less elastic than the price elasticity for Pepsi.

Income Elasticity of Demand Coefficient

The income elasticity of demand measures how responsive the demand for a good is to changes in income. A higher income elasticity indicates that demand for a good is more sensitive to income changes. A very high income elasticity suggests that an increase in consumer income will greatly increase the demand for that specific good. On the contrary, a very low price elasticity implies that changes in consumer income have minimal impact on demand for a good.

Economists have guidelines for classifying products as luxury goods, normal goods, or inferior goods based on the coefficient of income elasticity of demand:

  • Luxury goods have an Income Elasticity of Demand (IEoD) greater than 1, indicating they are income elastic.
  • Normal goods have an IEoD equal to 1 and a positive elasticity of demand (IEOD), indicating they are income inelastic.
  • Inferior goods have an IEoD less than 0 and negative income elasticity.

The differences between these terms are important because they help us understand how supply and demand work in a market. The concept of demand elasticity is crucial for this understanding.

The Markup rule in economics is used to explain how firms make pricing decisions. According to this rule, the price charged by a firm is determined by adding a markup to its marginal cost. This

markup is calculated by taking the inverse of the price elasticity of demand and subtracting it from one. Therefore, the equation P'(P/Q) = (1 / price elasticity of demand) = (1 / ?) holds true. This equation can also be written as P(1 - 1 / ?) = MC, or in other words, the price multiplied by (1 - 1 / ?) equals the marginal cost. Here, ? represents the inverse of the price elasticity of demand.
A firm with market power will set its price above the marginal cost since it aims to maximize its profits. In contrast, a competitive firm faces perfect price elasticity of demand and sets its price equal to the marginal cost. The Markup rule also implies that a monopolistic firm will never choose to operate on the inelastic portion of its demand curve. Moreover, for equilibrium in a monopoly or an oligopoly market, the price elasticity of demand must be greater than one (1 / ? > 1).

(Mas-Collel) 2. The cross-price elasticity of demand quantifies how the demand for good A shifts when the price of good B changes, whereas the price elasticity of demand for A measures how the demand for good A adjusts to a change in its own price (i.e., the price of A).

The concept of cross-price elasticity focuses on how changes in price within a particular market impact demand patterns. This differs from the concept of price elasticity of demand, which measures how demand responds to changes in price alone. Cross-price elasticity instead measures how demand responds to changes in the prices of other goods, whether they are substitutes or complementary goods.

Income Elasticity of Demand

In

contrast to the previous examples, income elasticity of demand seeks to measure how demand responds to variations in consumer income levels. The goal is to determine the coefficient of income elasticity of demand, which indicates how the demand for good A would change when consumer income fluctuates. For instance, data on price indices for new cars and used cars could be employed as substitutes.

It is expected that with the decrease in the price of new cars relative to consumers' incomes, there will be an increase in demand for new cars and a decrease in demand for second-hand cars. There has been a noticeable decline in the prices of second-hand cars.

Figure 2: Complementary goods have complementary demand, such as DVD players and DVD videos. When the price of DVD players decreases, more are purchased, leading to an expansion of the market demand for DVD videos. The cross price elasticity of demand for two complementary goods is negative. The coefficient of cross-price elasticity of demand is higher when there is a stronger relationship between the goods. For example, when there are two close substitutes, the cross-price elasticity will be strongly positive. Similarly, if there is a strong complementary relationship between two products, the cross-price elasticity will be highly negative.

Products that have no relation do not have cross elasticity of demand. Determine if demand would be more or less elastic for the following three factors affecting elasticity of demand:

Availability of substitutes Elasticity of demand

If there are substitutes available, an increase in the price of the product would cause consumers to switch to a similar alternative. Therefore, demand would be elastic.

Cross-price elasticity of demand: If the two products are

substitutes, the cross elasticity of demand will be greater than zero (0) or positive. If the price of one product increases, the demand for the other will also increase, resulting in a positive cross elasticity. If the products are perfect substitutes, the cross elasticity of demand is equal to positive infinity.

Income elasticity of demand analyses the impact of price changes on demand, specifically regarding substitute goods and services. The perception of a necessity versus a luxury may vary among individuals. In numerous cases, the ultimate income elasticity of demand tends to approach zero, indicating minimal connection between income and spending choices. As a result, a decrease in prices is expected to lead to only a minor "real income effect".

The relationship between the elasticity of demand for a good and the share of consumer income spent on it

When a product's price represents a larger percentage of a consumer's income, the elasticity of demand for that product increases. This is because consumers are more conscious of the cost when it takes up a greater portion of their income.
The percentage of consumer income also impacts cross-price elasticity of demand. If there is a change in price for a product, consumers are more likely to switch to substitute products if that particular product accounts for a higher percentage of their income.
The impact on demand for goods due to changes in income depends on whether they are considered necessities or luxury items. Necessities will experience an increase in demand with rising incomes, but at a slower rate compared to luxury goods. Instead of solely purchasing more necessities, consumers will use their increased income

to buy more luxury goods as well.
During periods when incomes rise, there is a greater increase in the rate at which demand rises for luxury items than necessities. Consequently, luxury goods have an income elasticity greater than 1, normal goods have an income elasticity between 0 and 1, while inferior goods have an income elasticity less than 0 (zero).

Consumer’s time horizon Elasticity of demand

The elasticity of demand increases as the duration of a price change extends, allowing consumers more time to seek alternatives. In the case of sudden fuel price increases, initially consumers may refill their tanks; however, if prices remain high for an extended period, more individuals will reduce fuel consumption by carpooling or using public transportation and purchasing more fuel-efficient vehicles. Nonetheless, this principle does not apply to consumer durables such as cars since eventually they need replacement, resulting in less elastic demand. Time plays a crucial role in determining how both consumers and producers respond to price fluctuations. The longer individuals have to adapt, the greater adjustments they can make. Cross-price elasticity of demand follows a similar pattern with elastic long-term demand.

The income elasticity of demand refers to how responsive demand is to changes in income. For luxury items, the elasticity is greater than 1. For normal goods, it falls between 0 and 1. Inferior goods have an elasticity less than 0.

Differentiating between perfectly inelastic demand and perfectly elastic demand, the former occurs when a product's demand is unaffected by price changes because there are no substitutes available and consumers continue buying the same quantity regardless of price.

On the other hand, perfectly elastic demand happens when even a small change

in price leads to an infinite change in demanded quantity. This implies that there are many substitutes available and consumers are highly sensitive to price fluctuations.

When demand is perfectly elastic, the quantity demanded remains constant at the equilibrium price. An increase in price will cause consumers to stop buying the item. The coefficient of elasticity is infinite.

G. Explain the relationship between elasticity of demand and total revenue for different ranges along the demand curve, using the "Graphs for Elasticity of Demand, Total Revenue" provided. Also include the impact on quantity demanded and total revenue when there is a price decrease, ceteris paribus. 1.

Elasticity of demand is a valuable tool for assessing the impact of price changes on the quantity demanded and produced by a firm. When considering a price change, a firm must analyze its effect on total revenue. This change in price will have two effects: the price effect and the quantity effect. The price effect states that an increase in unit price will increase revenue, while a decrease in price will decrease revenue. On the other hand, the quantity effect explains that an increase in unit price will result in fewer units sold, while a decrease in unit price will lead to more units sold. Due to the inverse relationship between price and quantity demanded, these two factors impact total revenue in opposing directions. However, a firm must determine the net effect to decide whether to increase or decrease prices. Elasticity serves as the tool for this purpose, as it allows for calculating the percentage change in total revenue by considering both the percentage change in quantity demanded and the percentage change in

price (one positive and one negative). The relationship between elasticity of demand and total revenue applies to any good. For instance, if the price elasticity of demand is perfectly inelastic (Ed = 0), changes in price will have no effect on the quantity demanded for the good.Increasing the price leads to an increase in total revenue. If the price elasticity of demand is relatively inelastic (|Ed| ;1), the percentage change in quantity demanded is smaller than the percentage change in price. Consequently, when the price is increased, the total revenue increases, and vice versa. Conversely, if the price elasticity of demand for a good is unit elastic (|Ed| = 1), the percentage change in quantity is equal to the percentage change in price. Therefore, changing the price does not affect total revenue. On the other hand, if the price elasticity of demand is relatively elastic (|Ed| ;1), the percentage change in quantity demanded is greater than the percentage change in price. This means that when the price is raised, the total revenue decreases, and vice versa. Moreover, if the price elasticity of demand for a good is perfectly elastic (Ed is infinite), any increase in price, no matter how small, will cause demand for the good to drop to zero. Consequently, when the price increases, the total revenue drops to zero. The maximum total revenue occurs when the combination of price and quantity demanded results in unitary elasticity of demand. To maximize profits, a firm selects the quantity to sell that equates its marginal revenue (the change in revenue from selling one additional unit) to its marginal cost (the change in total cost resulting from

producing one additional unit).The markup rule states that the firm's ability to price its goods over cost depends on its market power, which in turn depends on the price elasticity of demand faced by the firm (Wapedia 2010).

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