Price Elasticity of Demand - Research Paper Example

? Price Elasti of Demand of the ? Introduction The theory of economics explains want as a desire made by consumers for consumption of goods or services. The demand created by consumers is an effective desire. It is a want for a product or a service that is backed by purchasing power necessary for consumption and proper willingness to buy it (Lorenzoni, 2006). When a child learns a chapter of science from mother then it becomes a want for the service of education. If that very student goes for a private tuition, then it becomes a demand because certain money has to be paid to the tutor. The father of economics Alfred Marshall explained the Law of Demand. The Law explains that keeping all other factors affecting demand constant, the quantity demanded for a product or a service at a particular point of time is inversely proportional to its price. Thus, price and quantity demanded has an inverse relation with each other. The higher is the price level, lower will be the consumer willingness to buy a product or a service. As a result, the demand curve is always negatively sloped according to the law of demand. (Source: Author’s Creation) The above figure reflects the demand curve where Q stands for quantity demanded for a product or a service and P is the price level. There are also other factors that affect quantity demanded. This essay will briefly explain the different determinants of demand, assuming the impact of one variable on demand is analysed provided all the other factors are given. The income of consumers is positively related to the quantity demanded for goods and services. The higher is the income of the consumers the greater is their level of purchasing power thus consumers will always demand more with the rise in income levels. The quantity demanded also depends on the tastes and preferences of the buyers. When analysed in details the quantity demanded for a product or service is largely dependent on the complementary and substitution effect. For instance, the quantity demanded for Pepsi will always be increasing with the rise in the price level of Coke. Again the demand for cars will drastically fall with the rise in fuel price. There are other products like Bajra also known as inferior goods, whose quantity demanded falls with rise in income of the consumers. The nature of goods concerned is also an important parameter to analyse the quantity demanded for a good or a service. The goods reflecting status symbol always show a positive price effect in the quantity demanded. For example, the demand for a house sold in auction. Necessities are other types of goods that are insensitive to the changes in price, like the demand for life saving drugs. Price Elasticity of Demand Elasticity of demand is a quantitative measure that shows the degree of responsiveness of quantity demanded for a product or a service with respect to the changes in the various determinants of demand (IOWA State University, 2007). Price elasticity of demand shows the degree of responsiveness of quantity demanded for a commodity or a service with respect to chances only in its price level keeping all other factors affecting demand constant (Andrews & Benzing, 2010). The basic method of calculation of price elasticity of demand (Ep) is:- Ep = dQ/Q dP/P P and Q stands for price and quantity while dQ and dP shows the change in quantity demanded and price respectively (Litman, 2004). In order to make the analysis easy, economists take the mod values for calculating price elasticity of demand. The table below shows the five basic variations in price elasticities of demand. Value Types of elasticity’s Ep = ? Perfectly Elastic Ep = 0 Perfectly Inelastic Ep = 1 Unitary Elastic Ep > 1 Relatively Elastic Ep < 1 Relatively Inelastic (Source: Traczynski, 2007) The above five variations in elasticity are all measured in terms of their mod values. Impact of Price Elasticity of Demand The quantity demanded by the consumers technically depends on the different values of price elasticity of goods and services. It shows the ways sellers and buyers in the economy respond to price changes. (Source: IOWA State University, 2007) The figure above shows a situation when the % change in quantity demanded is almost nil to the % change in the price of a commodity or a service. This is the case of perfectly inelastic demand; it is a hypothetical case in economics. This kind of a pattern can be found in case of demand made for necessary goods like medicines (Boyes & Melvin, 2010). No matter what is the rise in price level, consumers can never deny the purchase of a life saving drugs till the last bit of resource is available. This is the reason for which pharmaceutical firms enjoy monopoly power in the economy. Perfectly inelastic demand is also found in situations where goods demanded are objects of addiction; like the drug addicts purchase drugs with high prices. If the price of a product is very low like the price of a match box, then if its price rises by 100% the quantity demanded remains same. (IOWA State University, 2007) The case considered above is another hypothetical extreme condition of perfectly elastic demand. This is a situation where even if the price of a commodity or a service does not change it largely changes the quantity demanded for it. Buyer in the market can respond in this way to sudden shocks in the in the economy (Landsburg, 2010). This pattern of demand can be created by consumes when there are large number of substitutes available for a particular commodity or a service. If a country has a large workforce participation rate then the quantity of labourers demanded by the industrialists may vary from time to time according to the magnitude of profit made by them. (IOWA State University, 2007) The case above to be studied is a case of relatively inelastic demand curve. This is a situation when the % change in quantity demanded is less than the % change in price of a commodity or a service. If the number of substitutes available for a product is very few then the quantity demanded for that commodity is relatively inelastic. When two goods satisfy the same type of demand made by the consumers then those goods are known as substitute goods; example coffee and tea. So if the price of a good with less number of substitutes increases then the potential buyers has less options to shift to other substitutes. Although the overall quantity demanded will fall but the magnitude by which it will decrease will be less than that of the price level. Like very few companies in the economy produce tyres for cars so even if the price of tyre in a company rises then the buyers has less options to shift out and demand for tyres of other companies. A commodity may also have relatively inelastic demand if many goods are complementary to it. For example petroleum in some form is required for different kinds of productive activities in the economy. Although the price of petroleum used by a country is increasing in the current period but still the quantity demanded for it cannot fall drastically. No matter how much the cost of production increases the level of petroleum to be imported cannot fall, provided all the productive activities in that nation are operating. (IOWA State University, 2007) The next case considered above is the case where a good or a service has a relatively elastic demand. The % change in quantity demanded is more than the percentage change in price of it. It is the case just opposite to that of relatively inelastic demand. If a product has very few complementary goods to it and a large number of substitutes then its price elasticity is likely to be relatively elastic. The best examples of such goods are the luxury and comforts like shampoo, mobiles, air conditioners etc. At present more than 30 companies are involved in the production of consumer goods like shampoo; so if the price of shampoo set by any particular company increases then it will surely create a detrimental impact in the quantity demanded for that company. This is because the buyers will have a wide spectrum of different types shampoos to consume on that ground. (IOWA State University, 2007) The last general case to be considered is another hypothetical condition where the price elasticity of demand for a commodity is unitary elastic (Lipsey & Harbury, 1992). This is the situation when the % change in price level is same with respect to the % change in quantity demanded. This situation can be observed in a market where the number of substitutes for a commodity is almost equal to the number of complements. Price elasticity of demand is actually a quantitative measure that throws a light on the Law of Demand based on the assumption of Ceteris Paribus. In most of the cases goods have negative price elasticity of demand except two special cases. The price elasticity of demand for Giffen goods is always positive. Giffen goods are those inferior goods whose price constitutes a major part the buyer’s income (Baruch and Kannai, n.d.). If the price of these goods increases then it increases the quantity demanded, this is because the buyers who are poor feels that the price of the good would increase further in future. This concept was introduced by Robert Giffen who had found in 1996 that although the price of potato in Scotland was increasing the quantity demanded for it did rise instead of falling. The price elasticity is positive even for goods that exhibit Veblen Effect. The consumers often feel that the price of a good is high because it is of a better quality (Bagwell & Bernheim, 1996). It is believed by them that a better quality product has to be expensive. So as the price level of such goods increases the quantity demanded for them also rises. Conclusion Understanding price elasticity of demand is the most crucial factor for all the economic activities undertaken especially by the producers. Revenue=Price *Quantity demanded, in order to maximize the revenue the producers must realize the optimal level of price. It will be easier to increase revenue for those products whose price elasticity is relatively inelastic. This is because a substantial rise in the price level will not create a large fall in quantity demanded. On the contrary, those commodities that have relatively elastic demand may have large fluctuations in quantity demanded with respect to changes in price levels, so to maximize revenue, the sellers must not suddenly increases the price levels. Thus, producers must always analyse the price elasticities of the products sold by them. It should be considered that the revenue maximizing price level might not be the profit maximizing level for a commodity or a service. References Andrews, T., & Benzing, C. (2010). Simplifying the price elasticity of demand. Journal for Economic Educators. 10(1), 1-13. Bagwell, L. S., & Bernheim, B. D. (1996). Veblen effect in the theory of conspicuous consumption. Retrieved From http://www0.gsb.columbia.edu/faculty/lhodrick/veblen%20effects.pdf. Baruch, S., & Kannai, Y. (n.d.) Inferior goods, giffen goods, and shochu. Retrieved from http://home.business.utah.edu/finsb/giffen.pdf. Boyes, W. J., & Melvin, M. (2010). Microeconomics (8th ed.). Connecticut: Cengage Learning. IOWA State University. (2007). Elasticity of demand. Retrieved from http://www.extension.iastate.edu/agdm/wholefarm/pdf/c5-207.pdf. Landsburg, S. (2010). Price theory and applications. (8th ed.). Connecticut: Cengage Learning. Lipsey, R. G., & Harbury, C. D. (1992). First principles of economics. (2nd ed.). Oxford: Oxford University Press. Litman, T., (2004). Transit price elasticities and cross-elasticities. Retrieved from http://www.nctr.usf.edu/jpt/pdf/JPT%207-2%20Litman.pdf. Lorenzoni, G., (2006). A theory of demand shocks. Retrieved from http://economics.mit.edu/files/1802. Traczynski, J., (2007). Elasticity and incidence. Retrieved from http://www.econ.wisc.edu/grad/TA%20manual%20docs/elasticity.pdf. Read More