Elasticity of Demand and Cross-Price Elasticity - Essay Example

?Economics A. Definitions of Terms: Elasti of Demand Demand Elasti is the elasti or volatility of a certain good or service’s quantity demanded value when certain factors of the demand are altered. The most common of these factors is the Price Elasticity of Demand, wherein it measures the volatility of the product’s demand by the consumers should it be subjected to price changes, whether an increase or decrease in price. If the quantity demanded of a certain product changes minimally or does not change at all, then that product is said to be a Price Inelastic Good. Consequently, if a product whose price increased and such a change brought forth an abrupt drop in quantity demanded of the same product, the good is said to be Price Elastic. In a perfectly competitive market where the consumer is well-informed of the prices of all commodities sold in the market, Perfectly Price Elastic goods are said to exist, wherein even just a very small increase in the price of the good will make the quantity demanded drop to zero. Cross-Price Elasticity (with Substitutes and Complements) Whereas Elasticity of demand refers only to one product, Cross-Price Elasticity is a study of demand elasticity between two goods in the market. Cross-Price Elasticity refers to inter-relation of two goods in the market, looking into the effects that an increase in the price of Good A procures to the quantity demanded of Good B. If an increase in the price of Good A increases the quantity demanded of Good B, then the two goods are said to be Substitutes, where Good A could just substitute and replace Good B, and vice versa, for the consumer demand. However, should the increase in the price of Good A pulls down the quantity demanded for both products, then it can be said that the pair of goods is a Complements. Income Elasticity (with Normal and Inferior Goods) Income Elasticity differs from the above mentioned elastic measurements in that Income Elasticity measures the responsiveness of product to the changes in the wage of the consumer. It looks into how the consumer market would most likely react should the wages of the consumers increase and that they have more buying capability. There are 3 types of goods based on the outcome of this measurement: Luxury Goods, Normal Goods and Inferior Goods. Luxury Goods are highly Income Elastic. If the wages of the consumers go up, more Luxury Goods will be bought by the consumer population, rising in a somewhat exponential rate. Consequently, if the wages of the consumers go down, Luxury Goods will suffer in that the quantity demanded for such goods will abruptly drop. A Normal Good, on the other hand, is still income elastic, but not as much as Luxury Goods. These are goods that would increase in quantity demanded should the wages of the consumers increase and would decrease if the later decreases too. Normal Goods do not suffer as much as Luxury Goods should income levels go down, consequently, they do not enjoy as much as Luxury Goods should income levels go up. Inferior Goods, unlike the other two, are negatively income elastic. Any change in the income levels of the consumers would only cause minimal to naught changes in quantity demanded. Examples of Inferior Goods are inexpensive goods, such as basic canned goods, sardines, bologna, and the like, wherein if income is restricted, consumers could just resort to these inexpensive goods, and thus not likely to affect demand. B. Elasticity Coefficients Demand Elasticity Since Demand Elasticity measures the responsiveness of the quantity demanded for a good to its price, only two variables are required for the solution: the percentage of change in quantity demanded (%?QD) and the percentage of change in the price (%?P). Demand Elasticity is merely the ratio between the %?QD and %?P. To interpret the results of the formulas, refer below (Gillespie, 2007): Elasticity = 0; the good is perfectly inelastic. -1 < Elasticity < 0; the good is relatively inelastic. Elasticity = -1; the good is unitary elastic. -? < Elasticity < -1; the good is relatively elastic. Elasticity = -?; the good is perfectly elastic. Cross-Price Elasticity Quite similar to Price Demand Elasticity, Cross-Price Elasticity needs two variables: %?QD for Good X and %?P for Good Y. Still similarly, Cross-Price Elasticity is still the ratio between %?QDX and %?PY. To interpret the results of the formulas, refer below (Mofatt, Cross-Price Elasticity of Demand): Elasticity > 0; the goods are substitutes. Elasticity = 0; the goods are independent. Elasticity < 0; the goods are complements. Income Elasticity Still like the first two, Income Elasticity requires only two variables, one is still the same, but the other is different. The two variables are %?QD for the good and the percentage change in income (%?Y). Income Elasticity is still the ratio between the two variables %?QD and %?Y. To interpret the results of the formulas, refer below (Mofatt, Cross-Price Elasticity of Demand): Elasticity > 0; the good is a normal good. Elasticity > 1; the good is a luxury good. Elasticity < 1; the good is a necessity good Elasticity = 0; the good is resistant to changes in income. Elasticity < 0; the good is an inferior good. Interpretation of Results C. Contrasting the three The three, demand elasticity, cross-price elasticity, and income elasticity greatly differ from each other in focus and interpretation. Demand Elasticity measures the responsiveness of the quantity demanded to the price of the good, looking into how intense the impact of such change has to the quantity demanded of the good. Business owners and people involved in the making of decisions in a business firm looks into Demand Elasticity should they consider raising the price of their goods in order to gain more profit. Cross-Price Elasticity, on the other hand, measures the responsiveness of a product’s quantity demanded against the increase in price of another product. For business owners, they use this measurement to assess the capacity of their product to gather more sales than the competing businesses offering other goods in the market or to stay profitable if their complements would increase in price, and implement necessary marketing realignment to effectively sell their products. As for Income Elasticity, it measures the responsiveness of the quantity demanded of the good to the income levels of the population. It measures the capacity of the consumers to purchase a good on the market, considering the changes in their income levels. Once again, business owners make use of this information to assess the desirability of their products in case the capacity of the consumers to buy increases or decreases, and then take the necessary steps to promote profit (if income levels increase) or to contain loss (if income levels decrease). D.  Explain whether demand would tend to be more or less elastic for each of the following three determinants of elasticity demand:  Availability of substitutes  The presence and easy accessibility to substitutes of a good could be the most influential factor to the elasticity of any good or service (Investopedia). With substitutes easily accessible in the market, any small increase in the price of the good could result in the drop of the demand of such a good and switch the demand to the substitute. The more substitutes present in the market, the more elastic the goods are. For example, a good substitute for Good A is Good B. If the price of Good A increases even just by a couple of dollars, basing on the Cross-Price Elasticity of the substitutes, more people would resort to Good B instead, pulling the quantity demanded of Good A down and of Good B up. Share of consumer income devoted to a good  Technically, in any increase in the price of good and with income levels remained as is without any prior changes, quantity demanded would decrease, depending upon the share of the good to the consumer income (Investopedia). For a good that requires a large portion of the consumer’s income, demand for such a good may be diminished or the good may removed from the consumption of the person if the income of the consumer decreases or the price of the good independently increases. Consequently, for a good that requires just a small portion of the consumer’s income, the quantity of the good demanded by be reduced, considering the good is a normal good or a luxury good, still with the pretext that the income of the consumer decreases or the price of the good increases. For example, if the price of Good A increases from $10-$15 and that the consumer allotted $30 for consuming Good A, then there would not be enough to buy the usual 3 units of Good A, and instead will only be settled on only 2 units. This shows the income elasticity of Good A. Consumer’s time horizon  Time also plays as a factor for elasticity of the product. Investopedia illustrated such a factor through the use of cigarettes (Investopedia). It says there that if the prices of cigarettes go up by $2, consumers would not be able to replace the product with any substitute and that consumers are not willing to lessen their consumption of cigarettes. However, if the consumer realizes that they could not spend an excess of $2 for cigarettes, then slowly, the consumer cuts off their consumption of cigarettes and ultimately, lessen the quantity demanded of cigarettes. E. Example + Impact on Business Decision Making Process Availability of Substitutes An example of a good that has a lot of substitutes would be rice. Rice is a staple crop in most tropical countries and is a good source for Carbohydrates. A lot of people consume rice in their diet and allot money for it. However, due to natural calamities in the tropics, rice crops are damaged and supply of rice fluctuates. This causes rice to be more expensive. For the consumers who could not afford expensive rice, they often resort to bread as a source of carbohydrates for their bodies. This greatly affects Business Decision-Making Processes because it would deal with the amount of revenue and loss of a business, which in the example, is the agro-food businesses of the farmers. On the other hand, an example of a good that does not have any close substitutes would be oil products, such as gasoline, diesel, petrol, etc. A car that runs on gasoline could not take in diesel as fuel; otherwise, the engine would break-down and could risk a system failure and an overhaul. There are no close substitutes for gasoline on vehicles running on gasoline. Share of consumer income devoted to a good  Consider a setting wherein there is 10% inflation rate on the market economy for a quarter, which means that the prices of goods are increasing at a rate of 10% in just a span of 3 months. Now consider two goods: gasoline, where the average mileage needed by a certain individual to transport himself from his home to his workplace costs $170 per month such that $180 is devoted to the good for consumption, and a can of soda, whose average consumption per month is $30, with $3 per can. In 3 month’s time, the price of transportation through gasoline would be $187, with an increase of $17, while the price of a can of soda is $3.30, increasing for only $0.30. For a consumer whose average income is just $300, he or she might cut-off his transportation cost from his regular month consumption and would more or less revert to public transportation or cheaper methods of getting to the workplace, while only minimizing the quantity of his or her consumption of soda, depending on how many cans could be bought with $30 a month. Such is the effect on Business Decision-Making Processes; the business owners would now make a decision if selling the goods at a low price with more items being bought will be more profitable than selling the product at a high price but with lesser items bought. Consumer’s time horizon  The above mentioned section already displayed a good example for this determinant. Cigarettes, should their price increase, would gradually decrease their sales because consumers will find it less economically to spend an extra $2 for a pack of cigarette. The gradual loss on sales will be the effect inflicted on the Business owners, of which they would have to focus on innovating their products and the technology they use for production to achieve more efficiency and maintain profit. F. Perfectly Elastic Demand vs. Perfectly Inelastic Demand (with graphs) Figure 1. Image taken from Economics Help (Economics Help). The above graph shows a Perfectly Elastic Demand. It shows that at a certain price level, quantity demanded is infinite (ecoteacher). Any slight changes in the price level would cause the price level to drop to zero. That means, if a certain good is Perfectly Elastic, any slight increase in its price, assuming that the consumers has perfect access to information, will cause a sharp drop on the demand for the product to a zero sales. Figure 2. Image taken from Economics Help (Economics Help). The next graph shows the exact opposite of the Perfectly Elastic Demand; this graph shows the Perfectly Inelastic Demand of a product. The graph tells us that no matter what the price of the product is, quantity demanded will always stay the same. Prices could go up, prices could go down, but the same units of goods are still demanded. G. Explain the relationship between elasticity of demand and total revenue for the following ranges along the demand curve, using the attached “Graphs for Elasticity of Demand, Total Revenue.” Include the impacts to quantity demanded and total revenue when there is a price decrease, ceteris paribus.  Ceteris Paribus, Elastic range This refers to the range on the graph wherein the quantity demanded is between the minimum point of the unit-elastic range (QD=4) and one (QD=1). The graph illustrates that the farther the elasticity of a product is to the unit-elastic range, the lesser revenue the company will get from selling the product. The continuous increase in price, coupled with the continuous decrease of quantity demanded, yields lesser Total Revenue for the firm. Inelastic range The Inelastic range goes between the maximum point of the unit-elastic range (QD=5) to the point where line intercepts the x-axis at QD=9 (wherein the P=0 and TR=0). This illustrates further that the farther the product is from the unit-elastic range, with lesser price, the lesser revenue the company will be able to get from selling the product. In case of any price decrease, Quantity demanded will further increase and as such cause more losses in Total Revenue. Unit-elastic range The Unit-elastic range refers to the part of the graph where the quantity demanded yields the maximum total revenue for the product (4?QD?5). This means that as the amount of goods demanded in the market nears to the unit-elastic range, total revenue is nearing its maximum value. H. Bibliography Credit Union SA. (n.d.). Economics Teacher's Society of South Australia. Retrieved April 17, 2011, from http://www.ecoteacher.asn.au/Demand/elastsli/e14.htm Economics Help. (2008, December 30). Perfectly Elastic Demand. Retrieved April 17, 2011, from http://www.economicshelp.org/blog/economics/perfectly-elastic-demand/ Economics Help. (n.d.). Price Elasticity of Demand. Retrieved April 17, 2011, from http://www.economicshelp.org/microessays/equilibrium/price-elasticity-demand.html Gillespie, A. (2007). Foundations of Economics. New York: Oxford University Press. Investopedia. (n.d.). Demand Elasticity. Retrieved April 17, 2011, from http://www.investopedia.com/terms/d/demand-elasticity.asp Investopedia. (n.d.). Economics Basics: Elasticity. Retrieved April 17, 2011, from http://www.investopedia.com/university/economics/economics4.asp Mofatt, M. (n.d.). Cross-Price Elasticity of Demand. Retrieved April 17, 2011, from http://economics.about.com/cs/micfrohelp/a/cross_price_d.htm Mofatt, M. (n.d.). Income Elasticity of Demand. Retrieved April 17, 2011, from http://economics.about.com/cs/micfrohelp/a/income_elast.htm Mofatt, M. (n.d.). Price Elasticity of Demand. Retrieved April 17, 2011, from http://economics.about.com/cs/micfrohelp/a/priceelasticity.htm Read More