The Concept of Price Elasticity in Supply and Demand - Essay Example

1) i) Market can be defined as an or mechanism that brings together buyers and sellers of a particular goods, services or resources in order to determine a price and set equilibrium at point where the plans of buyer meet the plans of the sellers. From the above point, it is very clear that market equilibrium occurs at price or a point where the buyers are willing to buy a particular quantity of goods at a going market price and similarly sellers are willing to sell the same quantity of the goods at the same price. In simple words, market equilibrium is related to demand and supply. In order to understand the equilibrium situation in detail, let's first look at the meaning of the terms, demand and supply. Demand, simply, is a schedule or curve that shows the various amounts of a product that consumers are willing and able to buy at each of a series of possible prices during a specified period of time. The key words in this definition are 'ability' and 'willingness'. By ability we mean that the consumer must have enough income or resources to meet the prices, and by willingness, it simple means that the buyer should want to buy the products. Only, if these two conditions are being satisfied, then a satisfied demand is registered in the market. To be more meaningful, the quantities demanded at each price must related to a specific period- a day, a week, a month. Saying that a consumer wants to buy 10 packets of chocolate at $10/each is useless unless a specific time period is states. Let's now tabulate a schedule of price and quantity demanded to derive a demand curve: Price/Pack of Chocolate Quantity Demanded of Chocolate 10 0 5 5 0 10 0 5 10 10 5 0 0 Quantity Price The above diagram and table reveals a fundamental characteristic of a demand. This characteristics states that as the prices falls, the quantity demanded rises and as price rises, the quantity demanded falls. In short, there is a negative or inverse relationship between the price and quantity demanded. In mathematical terms, there exists a negative or inverse relationship between the price and quantity demand, known as the law of demand. The basis behind this law of demand is common senses. People ordinarily do buy more of a product at a low price then at a high. In other words, price is an obstacle hat deters consumers from buying. Similarly, in any specific time period people will buy at a low price because it maximizes their diminishing marginal utility. There are two other reasons behind the law of demand. These are income effect and substitution effect. Income effect states that people enjoy high purchasing power as prices decrease and hence buy more. The substitution effect, on the other hand, states that at a lower price, buyers will substitute what is now a less expensive product for similar products that are more expensive. The relationship between price and quantity demanded for any product can be expressed as a simple graph, shown above. So, far our discussion of demand is for individual and not for a market demand. Market demand is also similar to the concept of individual demand. It involves add the quantities demanded by all consumers at each of the various possible and this will enable us to move from individual demand to market demand. PRICE FIRST BUYER 2ND BUYER 3RD BUYER TOTAL MARKET DEMAND 0 4 3 3 10 5 2 2 1 5 10 1 2 0 3 1ST BUYER 2ND BUYER 3RD BUYER MARKET p P P P + + = Q Q Q Q This was only the one side of market and tells us partly about the market condition. The other side of the market consists of people who want to sell the goods to the buyers in order to earn profits. Like demand, supply is a schedule or curve showing the amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specific period. The willingness here means the supplier's conformity to the going market price and ability means that suppliers have enough resources to make the certain amount of products and supply them into the market. Let's now look at the behavior of supply, by tabulating the possible supply levels at each of the different market price. Let's use the same example of chocolate packs that were used in the demand table: Prices per Chocolate pack Quantity Supplied 0 0 5 5 10 10 10 5 0 0 0 5 10 Quantity Price The above supply table and graph could be used to make assumptions about the law of supply. The law of supply states that as the prices rises, the quantity supplied rises as well and as the price falls, the quantity supplied falls. This relationship is called the law of supply. The reason behind this positive relationship of the supply and price is because of the motivation of the supplier to sell more and more when the prices rise, in order to maximize his profit. Like the assumption used in the demand, analysis, we can also move from individual supply curve to market supply curve by adding the value of all individual supply curves. We can now bring together the supply and demand on the same graph to see how the buying decisions of buyer and suppliers meet to bring about an equilibrium price and quantity and lead to a situation of equilibrium in the market. However, let's first tabulate the plans of buyer and suppliers in a table form to have better understanding of the equilibrium situation. Price Quantity Supplied Quantity Demanded Condition in the market Reaction in the market 0 0 10 Shortage Queues, Increase in Price 5 5 5 Equilibrium No Reaction 10 10 0 Surplus Reduction in Prices The above table illustrates the different situations that may occur in a market and how these situation lead towards a position of equilibrium in the market. This equilibrium position can be represented in a diagram form as well: 0 5 10 10 5 0 D S Q P EQUILIBRIUM EQUILIBRIUM PRICE EQUILIBRIUM QUANTITY The above diagram clearly indicates the equilibrium position in the market, clearly identifying the equilibrium point, equilibrium quantity and equilibrium price. At this point, the plan of buyers meet the plan of sellers and quantity is determined at 5 and price at $5 where there is no misbalance in the market- shortage or surplus and no pressure on price or quantity. If, however, the price goes below $5, the quantity demanded will become greater than supplied and hence queues and price increase will occur until the market is back to equilibrium. Similarly, if price is above $5, the quantity supplied will be greater than demanded and hence supplier will find large quantities of unsold goods. They will be motivated to lower the price to get rid of unsold stock and situation will come back to equilibrium again. This is how equilibrium is determined in the market by the forces of demand and supply and how market corrects any disequilibrium and brings market back to the position of equilibrium. 1) ii) a) Demand and Supply both increase simultaneously. EQUILIBRIUM PRICE D2 q1 q2 10 p1,p2 0 D S Q P e1 NEW EQUILIBRIUM QUNTITY The initial equilibrium position in the market was e1, where the quantity supplied and demand and supply met to determine the quantity at point q1 and price at p1. At this position, equilibrium existed in the market. However, due to one reason or another, the market faced a boom and both demand supply increase simultaneously which brought changes to the price and quantity to the equilibrium position of the market. The increase in supply shifted the supply curve from s1 to s2 and demand curve from d1 to d2. As a result of this a new equilibrium was formed at a point e2 on the curve. The equilibrium quantity was also increase from q1 to q2. However, since the changes in demand and supply have occurred together, this has offset the effect of any of these changes on the price and price has remained unchanged at the point p1. b) Demand Increase while the supply deceases. q1,q2 p2 p1 D S Q P e1 The initial equilibrium position in the market was e1, where the quantity supplied and demand and supply met to determine the quantity at point q1 and price at p1. At this position, equilibrium existed in the market. However, due to increase in demand and reduction in supply, a new equilibrium was formed at point e2. At this point, the price is much higher than the previous equilibrium price of p1. The new price is p2. However, there has been no change in the quantity. The quantity remains at the previous equilibrium level of q1. 2) The concept of elasticity is the measure of responsiveness of change in quantity demanded, following a change in price. A demand or supply is said to be elastic if the quantity changes by a greater proportion than a change in the price. Similarly, demand or supply is inelastic if the change in quantity following a change in price is lesser in proportion than the price. Price Elasticity is said to be unitary, if the proportion of change in quantity is equal to the change in price. Similarly, the two extreme situation of price elasticity are perfectly elastic or perfectly inelastic. In perfectly elastic curve, the demand changes even when there is no change in price. In perfectly inelastic curve, however, the demand remains the same, no matter whatever is the price. Let's now look at the concept of elasticity taking the numerical examples of elasticity and there effects. 2) The demand is said to be price elastic when a little change in price causes too much change in quantity demanded. In other word when percentage changes in demand is greater than the percentage change in price. Elasticity = Percentage change in Quantity demanded/ Percentage Change in Price This can be proved by a numerical example also. The answer of the elasticity formula, if greater than 1, then the demand is said to be elastic. Suppose that for a certain product, the company has increased the price by 20%. As a result of this change, the resulting demand has fall by 60%. If we want to check the elasticity of the product we will plug in the above percentage in the formula. Elasticity = 60/20 = 3 Demand is usually elastic when the resulting answer for the formula is more than 1. This is useful for managers and decision makers as they choose to make better pricing decisions. For example, if managers know that the product that they are selling has a elastic demand, they would know that they cannot increase the price of their product in order to maximize revenues and hence profits. For example, any increase in prices in order to increase profit is going to decline the revenues for the company and in turn profits. Suppose that a firm is selling a product at $2. At the current the quantity it is selling is 40 Units. The total revenue that a firm earns is $80, at the current stage. However, the company decides to increase the price of the product to $4. This will result in the decline of quantity demanded to 18 Units. Hence the new revenue that would be earned by the firm is only $72 and hence a decline in the profit. This could be shown in the diagram form. P 4 2 18 40 Q From the diagram it could easily be seen that at the price $2 and quaintly 40, the area below the curve is greater than at the new situation when price increase to $4 and quantity is 18 units. This area represents the revenue and hence we can conclude that the smaller area means lesser revenue and how an elastic curve makes it unfavorable for the producers to increase prices. If we calculate at the elasticity of the situation we will get the following answer: Elasticity= (18-40/40*100)/ (2-4)/4*100) = 55%/50% = 1.1 And since the elasticity is greater than 1, it is not a good measure for the firm to increase prices as it is going to lose revenue, if it does that, as proved in the above part of discussion how the revenue has decrease from $80 to $72 as the price changes from $2 to $4. Similarly, inelasticity occurs if the responsiveness of Quantity demanded is smaller to the change in price. In other word, when a big change in price bring about a small change in quantity demand. The numerical value of inelasticity is lesser than and equal to zero. In this situation, it pays off if the producer increases the prices in order to increase his profit situation. Since, the increase in price is not going to affect the quantity demanded much, the producer is going to benefit from increase revenue and hence larger profit than otherwise he could have earned. For example, let's suppose that a producer again increases the price from $2 to $4. But as a result, the result quantity demanded changes from 40 units to 30 Units. In this case let's assess the revenue situation for the producer: Old Revenue = Price * Quantity = 2 * 40 = $80 New Revenue = Price * Quantity = 4 * 30 = $120 Hence, one can clearly assume that producers benefit from increasing the price of inelastic commodities in term of profits and large revenues. Let's now calculate the elasticity coefficient in this situation to prove our point that in case of inelastic demand, the numerical coefficient is always equal to or less than zero. Elasticity = 25%/50% = 0.5 This is how the producer benefits from an inelastic demand of product by raising prices. This can be shown through a graphical representation of areas under the curve in both old and new situations. Quantity Price 40 30 4 2 The graph clearly indicates that a big change in price has reduced the quantity be only a small amount and how revenue has increased as results. The knowledge of price elasticity is hence essential for producers while making pricing decisions to maximize their revenues and hence profits. 3) A monopoly is market condition where one supplier controls the entire supply in the market or there is only one producer of a good or service. A monopolist usually faces a downward sloping demand curve. This means that it cannot charge just any price for a given level of out because, depending on the price charged, a different quantity will be demanded. If he decides on price at which he is prepared to sell, the demand curve determines the quantity he can dispose of at the chosen price. Let's look at the situation of monopolist as a diagram: ACX MC AR MR P1 C Price Q1 The above diagram clearly shows that if the monopolist keeps the price at P1, the quantity demanded will be Q1. He cannot sell any higher quantity at price P1. Since the monopolist's demand curve is downward sloping, the MR will be less than price. Thus, when he equates MC or marginal cost to MR, it ensures that MC will be less than price. Because MC is always greater than a profit maximizing monopoly will produce at a point where marginal cost meets marginal revenue or where MC = MR. The monopolist will always produce where MR is positive, that is when the demand curve is elastic. In the figure, maximum profits are only attained when output is at OQ1 where MR = MC. At lower outputs each units produced adds more to the revenue than to cost. When output is greater than OQ, each addition unit adds more to cost than to revenue. The price at which OQ is can be sold is determined by the demand curve. Thus output OQ1 will marketed at price OP1. At output level OQ1 average cost is at its minimum point and monopolist makes a subnormal profit. Since, monopolist is only worried about his profits; we can see that his decision might not be in the best interest of the society. These decisions will result in higher prices and lower revenue as compared to a competitive market situation. For example, competitive market MR = AR, or socially optimum output. If monopolist produces at this point than only the society will get the maximum output and low prices. But, more often than not, monopolist works to fulfill his own ambitions at the cost of the society producing an output which is lower than socially optimum point and over-charging consumers to gain advantage of his highly leveraged position in the market. This makes a monopoly an undesirable market structure in most of the economies and government themselves usually devise anti trust law to discourage such condition in the market. The reason why governments are against this kind of market structure is because it exploits consumer by charging them higher prices and giving society a less output than a competitive structure would otherwise produce. References Richard Lipsey and Alec Chrystal. Economics. 10th Edition. Oxford University Press 2003. Campbell McConnell and Stanly Brue. Economics. McGraw-Hill (2005) Robert Pindyck and Daniel Rubinfield. Microeconomics. Prentice Hall (2004) John Sloman. Economics. Prentice Hall (2005). Read More