Microeconomics for Today - Price Elasticity - Assignment Example

PRICE ELASTI Price Elasti Part Introduction Price elasti shows the sensitivity of the quantity supplied, or the amount demanded to the price change. In other words, the price elasticity demonstrates how the quantity supplied or required will be affected by the price change (Mankiw, 2012). Price elasticity can be calculated by finding the ratio of change in percentage of the quantity to the change in percentage of the price. On a linear demand or supply curve, the following formulas of the price elasticity are used. Ep = (% ∆ Q) / (%∆P) Ep = ((∆Q) / (Q1)) / ((∆P) / (P1)) Ep = ((Q2 - Q1) / (Q1)) / ((P2 - P1) / (P1)) Ep = (% ∆ Q) / (% ∆P) Ep = ((∆Q) / (Q1)) / ((∆P) / (P1)) Ep = ((Q2 - Q1) / (Q1)) / ((P2 - P1) / (P1)) Where, Ep –Price elasticity Q1 –Initial quantity Q2 -Final quantity P1 –Initial price P2 –Final price It is worth to note that, though price elasticity has some relationship with the gradient of the line, it is not the gradient of the line. From the mathematics point of view, gradient of a line given by the ratio of change in y-axis to the change in the x-axis. Price elasticity is given by finding the “run over rise” or the ratio of the quantity change (x-axis) to the price change (y-axis). A curve will be elastic if it appears flat and will be more inelastic if it appears vertical. On a linear supply or demand curve, the elasticity is not constant in the whole curve. The reason behind this is that the respective percentage changes in both quantity and price are being measured. As you trend along a linear curve on approaching either of the axes, the change in the percentage of that variable axis gets smaller. The change in percentages of the axis variable gets bigger. The price elasticity is unit less since it is just a ratio of two variables with same units. Price elasticity is categorized into two ways. First, the demand price elasticity, according to the first law of demand, which states that a less quantity will be required when the price of the quantity increases. This law tells why the demand curve will slope down on the far right (Mankiw, 2012). The reason is that quantity and price moves in the opposite directions on a demand curve, the demand price elasticity is always negative. The figure below shows a price elasticity of a demand curve at various points along a linear demand curve. Q=8-P. From the equation, Q=8-P, to find the demand price elasticity (McEachern, 2012). Taking the price of three, the quantity is then 5=8-3 and at the quantity of three, the price is five. Ep = ((Q2- Q1)/ (Q1))/ ((P2-P1)/ (P1)) EP= (3-5/5)/ (5-3/3) EP=-0.6 The other category of the price elasticity is called supply price elasticity. The supply curve is made of a line that slopes upward towards the far right. Thus, the quantity supplied will be more if the price increases. The supply price elasticity is always positive. There are three essential components of the elasticity, which influences the business decision-making. Price elasticity of demand gives the responsiveness of demand when a price change occurs. The formulae for finding the coefficient of demand elasticity are given by the Ratio of the quantity demand percentage change to the price percentage change. The changes in quantity and price normally are in opposite directions, putting minus sign is not important. The primary concern is to the elasticity of demand coefficient (McEachern, 2012). For instance, taking the demand of rail services; at the time of peak, the railway transport demand becomes inelastic-higher prices are imposed by the rail companies and achieves higher profits and revenues. Cost price elasticity measures the responsiveness of the good X demand following the change in the price of another good, which is related. This element will make a clear distinction between the complementary and substitute products. The income elasticity of demand is a measure of the relationship between the change in quantity demanded and the change in income. The coefficient of the income elasticity is given by the ratio change in percentage of the quantity demanded to the change in the percentage of customers income. Part 2: Practical Application of Elements of elasticity Price elasticity of demand Let Ped denote price elasticity demand. Ped values will imply different elasticity in demands. 1. If Ped=0, the demand is perfectly inelastic-as price changes the demand does not change. The demand curve appears vertical. 2. If Ped is lies between one and zero, the demand is, inelastic-percentage change between two points in demand is less than price percentage change. 3. If Ped=1, the elastic demand is a unit, for instance if the price rises by fifteen percent it will result in fifteen percentage contraction in demand which leaves the total spending unchanged at each level. 4. If Ped˃ 1, the demand will respond more than proportionately as the price changes, that is, demand is elastic. For instance, if the price of a good increases by ten percent then this may lead to thirty percent decrease in the demand (Tucker, 2011). Factors influencing demand’s price elasticity 1. The close substitutes number-the higher the number of close substitutes in a market, the greater the elastic in demand is since customers are switching quickly. 2. Product switching cost-there is cost associated with switching. The demand tends to be inelastic. For instance, a phone service provider may insist on a twelve-month contract. 3. Necessity degree or whether good is a luxury- necessity goods are more inelastic in their demand while luxurious goods are more elastic in demand. 4. Consumer’s income proportion allocated to spend on a good-product with a high percentage of income will possess high elastic demand. 5. Duration allowed from the consumer to follow for price change- when demand is more price elastic, customers will take longer time to respond to the price change. The consumers have more time to look for cheaper substitutes and switch their spending. 6. Subject of good to habitual consumption-consumers may become less sensitive to the good’s price; this will make them purchase goods out of habit. 7. Demand peak and off-peak demand- price will be inelastic at peak times and will be more elastic at times of off-peak. This case mostly happens with the transport industry. 8. The definition broadness of a good or service- If a product is widely defined, that is, the demand for meat or petrol is often inelastic. However, for some particular brands of beef or gasoline are likely to be elastic which follows the price change. Demand’s elasticity and total revenue for supplier or producer. The relationship between firm’s total revenue and the elasticity of the demand is imperative. If the demand is inelastic-a rise in price will lead to increase in total income. If the demand is elastic, falling in price will result in the rise in total revenue. Off-peak, peak demand and price During holidays, prices for package are expensive; rail fares are costly at peak times. During the peak demand times, the market demand goes higher, and there are more prices inelastic. The will make large sales at high prices and make increased profits. The table below shows some relationships between prices; total revenue and the quantity demanded (Tucker, 2011). When price falls, the revenue initially goes up. For this example, the maximum value of the revenue will occur at the price of twelve dollars per unit, and when five hundred and twenty units are sold which gives total revenue of $6240. Price Quantity Total Revenue Marginal Revenue £ per unit Units £s £s 20 200 4000 14 18 280 5040 13 16 360 5760 9 14 440 6160 5 12 520 6240 1 10 600 6000 -3 8 680 5440 -7 6 760 4560 -11 Table 1 For instance, when the demand’s elasticity of price changes from say 20 dollars per unit to 18 dollars per unit. The percentage change in demand is forty percent following a ten percent change in price, which gives a demand elasticity of -4 (implying high elastic). In the above situation, when the demand is price-elastic, there is a decrease in price, which leads to higher consumer spending. If the price falls further than the estimated curve, leads to a reduction in the total revenue. Demand’s elasticity and indirect taxation Most products have indirect taxes. Goods like cigarette, which is taxed heavily in UK, together with fuel and alcohol, have a duty to them. When tax is high, there are costs of the business increase resulting in an inward supply shift (Tucker, 2011). The shifting burden of tax depends on the elasticity of the supply and demand. In general, the price elasticity of demand will affect the shifts in supply on the quantity and price in the market. Cross price elasticity of demand This element will make a clear distinction between the complementary and substitute products. Substitutes Substitute goods such as cereal, when there is an increase in product’s price, this leads to a rise in the demand for the rival good (McEachern, 2012). A cross price elasticity of two substitutes is positive. For instance, currently in the market, iPhone is giving competition to the Blackberry, which provides customers with push technology, in sending emails via mobile service. Another relevant example is the demand for the music. The sales of the digital music downloads have been escalating with the increase in broadband and the fall of the download prices. This condition results in the sales of the older music CDs to reduce exponentially. Complements Complements are found in joint demand. Cross price elasticity demand for double complements is (–ve) negative. The stronger the two products are related, the higher the coefficient of the cross price elasticity demand. When there is a strong relationship existing between two products, the cross price elasticity of the complements is more negative. Good example of such a condition is software games and games consoles. Unrelated products have a zero cross elasticity, for instance, the effect of bus fares will not affect market demand for the butter! When a competitor lowers the price of the rival product, the firm will use their estimates cross price elasticity demand to predict how their product affects the total revenue and the demand (Tucker, 2011). When pricing the complementary goods, for instance, soft drinks, popcorn and cinema tickets tend to possess high negative cross elasticity value. The behavior shows that they are stronger complements. Popcorns have a high markup- they cost few pennies to make but are sold for more pounds. Firms with a good estimate of cross price elasticity demand can predict the effect of saying a three-for-one offer of the cinema ticket on the popcorn demand (McEachern, 2012). The extra profit for excess popcorn sales will more than compensate the lower cost of entry to the cinema. For movie theatres, the cash collected from the concessions sections selling drinks, popcorns, and refreshments may generate more than forty percent of the year turnover. Cross price, elasticity is also affected by the brand. When consumers develop the habit of purchasing a product, the cross product elasticity of demand for the rival product reduces. Income elasticity of demand The coefficient of the income elasticity is given by the ratio change in percentage of the quantity demanded to the change in the percentage of customers income. Normal goods They have positive income elasticity. There are two types of normal goods that is, normal necessities and the normal luxurious. Normal necessities have income demand of between 0 and +1. Demand will rise with income though it will be less than proportionately. Usually, this happens because there is limited need to consume extra quantities of goods as the real living standards go up. Some examples of this case are like demand for the toothpaste, vegetables and newspapers. The demand does not depend at all on the fluctuations of the income; the total market demand is stable despite the change of the wider business cycle. Normal luxurious, these goods are said to possess an income elastic demand, which is greater than a positive one. One can manage without the luxurious goods (Mankiw, 2012). When incomes have strongly gone high, the consumers get the confidence to spend more, so the demand for luxurious goods goes high. In the economic slowdown or recession, these items are the ones, which, are first to be slotted out of the daily budgets. Most luxurious products deserve the sobriquet. For these goods, the consumer only derives the contentment not only by consuming the service or good but also by being seen as consumer by others. Inferior goods They have negative income elasticity of demand. Income rises as the demand falls. In the periods of recession, the demand may grow. In a given market, the income elasticity of the demand for different goods may vary and give the perception of the product from one consumer to another to differ. A good example for this case is the overseas market during the holidays develops this aspect. What to some people being viewed as necessary to others it is viewed as luxurious. For most goods, their ultimate income elasticity of demand is close to zero. This relationship shows that there is feeble link between the fluctuations in the spending and the income decisions (Tucker, 2011). Most of the effect on the demand is due to change in the relative prices. The income elasticity demand will vary with the time. For instance, currently there is growing a taste of the flat screen televisions as the market for plasma screens is developing. The demands income elasticity for television services transmitted through the satellite discs against the increasing availability and the decline in the cost (Mankiw, 2012). In general, the three elements of the price elasticity influences the market, understanding of them, and the customers will be able to make the right decisions based on them. Again, from understanding these elements clearly, the producers will be able to set right prices of their goods and services as per the demand of them and the supply. References Mankiw, N. (2012). Principles of economics. Mason, OH: South-Western Cengage Learning. McEachern, W. (2012). Microeconomics. Mason, OH.: South-Western Cengage Learning. Tucker, I. (2011). Microeconomics for today. Mason, OH: SouthWestern. Read More