DOWNLOAD PDF ELASTICITY OF DEMAND IN ECONOMICS

Transcription

1 Chapter 1 : Economics Basics: Elasticity Elasticity in this case would be greater than or equal to blog.quintoapp.com elasticity of supply works similarly to that of demand. Remember that the supply curve is upward sloping. Elasticity What is Elasticity? Elasticity refers to the degree of responsiveness in supply or demand in relation to changes in price. If a curve is more elastic, then small changes in price will cause large changes in quantity consumed. If a curve is less elastic, then it will take large changes in price to effect a change in quantity consumed. Graphically, elasticity can be represented by the appearance of the supply or demand curve. A more elastic curve will be horizontal, and a less elastic curve will tilt more vertically. When talking about elasticity, the term "flat" refers to curves that are horizontal; a "flatter" elastic curve is closer to perfectly horizontal. Elastic and Inelastic Curves At the extremes, a perfectly elastic curve will be horizontal, and a perfectly inelastic curve will be vertical. You can use perfectly inelastic and perfectly elastic curves to help you remember what inelastic and elastic curves look like: An Elastic curve is flatter, like the horizontal lines in the letter E. Perfectly Elastic and Perfectly Inelastic Curves Price elasticity of demand, also called the elasticity of demand, refers to the degree of responsiveness in demand quantity with respect to price. Consider a case in the figure below where demand is very elastic, that is, when the curve is almost flat. There are many possible reasons for this phenomenon. Buyers might be able to easily substitute away from the good, so that when the price increases, they have little tolerance for the price change. For instance, whereas a change of 25 cents reduced quantity by 6 units in the elastic curve in the figure above, in the inelastic curve below, a price jump of a full dollar reduces the demand by just 2 units. With inelastic curves, it takes a very big jump in price to change how much demand there is in the graph below. Possible explanations for this situation could be that the good is an essential good that is not easily substituted for by other goods. This means that consumers will need to buy the same amount of the good from week to week, regardless of the price. Inelastic Demand Like demand, supply also has varying degrees of responsiveness to price, which we refer to as price elasticity of supply, or the elasticity of supply. An inelastic supplier one with a steeper supply curve will always supply the same amount of goods, regardless of the price, and an elastic supplier one with a flatter supply curve will change quantity supplied in response to changes in price. How Is Elasticity Measured? As we have noted, elasticity can be roughly compared by looking at the relative steepness or flatness of a supply or demand curve. Thus, it makes sense that the formula for calculating elasticity is similar to the formula used for calculating slope. Instead of relating the actual prices and quantities of goods, however, elasticity shows the relationship between changes in price and quantity. To calculate the coefficient for elasticity, divide the percent change in quantity by the percent change in price: That is, even when an increase in price is paired with a decrease in quantity as with most demand curves, the elasticity will be positive; remember to drop any minus signs when finding your final value for elasticity. Page 1

2 Chapter 2 : Types of Elasticity of Demand Price elasticity of demand measures the responsiveness of demand after a change in a product's own price. Price elasticity of demand - key factors This is perhaps the most important microeconomic concept that you will come across in your initial studies of economics. The extent of responsiveness of demand with change in the price is not always the same. The demand for a product can be elastic or inelastic, depending on the rate of change in the demand with respect to change in price of a product. Elastic demand is the one when the response of demand is greater with a small proportionate change in the price. On the other hand, inelastic demand is the one when there is relatively a less change in the demand with a greater change in the price. For better understanding the concepts of elastic and inelastic demand, the price elasticity of demand has been divided into five types, which are shown in Figure Let us discuss the different types of price elasticity of demand as shown in Figure When a small change in price of a product causes a major change in its demand, it is said to be perfectly elastic demand. In perfectly elastic demand, a small rise in price results in fall in demand to zero, while a small fall in price causes increase in demand to infinity. The degree of elasticity of demand helps in defining the shape and slope of a demand curve. Therefore, the elasticity of demand can be determined by the slope of the demand curve. Flatter the slope of the demand curve, higher the elasticity of demand. In perfectly elastic demand, the demand curve is represented as a horizontal straight line, which is shown in Figure From Figure-2 it can be interpreted that at price OP, demand is infinite; however, a slight rise in price would result in fall in demand to zero. It can also be interpreted from Figure-2 that at price P consumers are ready to buy as much quantity of the product as they want. However, a small rise in price would resist consumers to buy the product. Though, perfectly elastic demand is a theoretical concept and cannot be applied in the real situation. However, it can be applied in cases, such as perfectly competitive market and homogeneity products. In such cases, the demand for a product of an organization is assumed to be perfectly elastic. However, a slight increase in price would stop the demand. A perfectly inelastic demand is one when there is no change produced in the demand of a product with change in its price. In case of perfectly inelastic demand, demand curve is represented as a straight vertical line, which is shown in Figure The demand remains constant for any value of price. Perfectly inelastic demand is a theoretical concept and cannot be applied in a practical situation. However, in case of essential goods, such as salt, the demand does not change with change in price. Therefore, the demand for essential goods is perfectly inelastic. Relatively elastic demand refers to the demand when the proportionate change produced in demand is greater than the proportionate change in price of a product. The numerical value of relatively elastic demand ranges between one to infinity. The demand curve of relatively elastic demand is gradually sloping, as shown in Figure It can be interpreted from Figure-4 that the proportionate change in demand from OQ1 to OQ2 is relatively larger than the proportionate change in price from OP1 to OP2. Relatively elastic demand has a practical application as demand for many of products respond in the same manner with respect to change in their prices. For example, the price of a particular brand of cold drink increases from Rs. In such a case, consumers may switch to another brand of cold drink. However, some of the consumers still consume the same brand. Therefore, a small change in price produces a larger change in demand of the product. Relatively inelastic demand is one when the percentage change produced in demand is less than the percentage change in the price of a product. Marshall has termed relatively inelastic demand as elasticity being less than unity. The demand curve of relatively inelastic demand is rapidly sloping, as shown in Figure It can be interpreted from Figure-5 that the proportionate change in demand from OQ1 to OQ2 is relatively smaller than the proportionate change in price from OP1 to OP2. Relatively inelastic demand has a practical application as demand for many of products respond in the same manner with respect to change in their prices. Let us understand the implication of relatively inelastic demand with the help of an example. The demand schedule for milk is given in Table Calculate the price elasticity of demand and determine the type of price elasticity. Page 2

3 Chapter 3 : Price elasticity of demand (video) Khan Academy Price elasticity of demand is an economic measure of the change in the quantity demanded or purchased of a product in relation to its price change. Expressed mathematically, it is. Study the patterns of numbers and see if you can analyse the relationships between the three measures of revenue â then answer the following: How are price and average revenue connected? What happens to total revenue as output increases? What is the connection between total revenue and marginal revenue? How are marginal revenue and average revenue connected? TR increases, reaches a peak and decreases. Why does a firm want to know PED? There are several reasons why firms gather information about the PED of its products. A firm will know much more about its internal operations and product costs than it will about its external environment. Therefore, gathering data on how consumers respond to changes in price can help reduce risk and uncertainly. More specifically, knowledge of PED can help the firm forecast its sales and set its price. Sales forecasting The firm can forecast the impact of a change in price on its sales volume, and sales revenue total revenue, TR. Pricing policy Knowing PED helps the firm decide whether to raise or lower price, or whether to price discriminate. Price discrimination is a policy of charging consumers different prices for the same product. If demand is elastic, revenue is gained by reducing price, but if demand is inelastic, revenue is gained by raising price. Non-pricing policy When PED is highly elastic, the firm can use advertising and other promotional techniques to reduce elasticity. Determinants of PED There are several reasons why consumers may respond elastically or inelastically to a price change, including: The degree of necessity of the good A necessity like bread will be demanded inelastically with respect to price. Whether the good is habit forming Consumers are also relatively insensitive to changes in the price of habitually demanded products. The proportion of consumer income which is spent on the good The PED for a daily newspaper is likely to be much lower than that for a new car! Whether consumers are loyal to the brand Brand loyalty reduces sensitivity to price changes and reduces PED. Life cycle of product PED will vary according to where the product is in its life cycle. When new products are launched, there are often very few competitors and PED is relatively inelastic. As other firms launch similar products, the wider choice increases PED. Finally, as a product begins to decline in its lifecycle, consumers can become very responsive to price, hence discounting is extremely common. Test your knowledge with a quiz Press Next to launch the quiz You are allowed two attempts - feedback is provided after each question is attempted. The effects of advertising Firms may use persuasive advertising by to win new customers and retain the loyalty of existing ones. Advertisers use a range of media, including television, press, and electronic media. Advertising will shift demand to the right, and make demand less elastic. There are three extreme cases of PED. Perfectly elastic, where only one price can be charged. Perfectly inelastic, where only one quantity will be purchased. Unit elasticity, where all the possible price and quantity combinations are of the same value. The resultant curve is called a rectangular hyperbola. PED can also be illustrated through indifference curve analysis Other stories. Page 3

4 Chapter 4 : 5 Types of Price Elasticity of Demand â Explained! Price elasticity of demand (PED) measures the responsiveness of demand after a change in price. Example of PED. If price increases by 10% and demand for CDs fell by 20%. In this case, the cross elasticity coefficient of complementary goods such as tea and sugar or car and petrol is negative. This is explained in Fig. If the two goods are unrelated, a fall in the price of good has no effect whatsoever on the demand for good X. In such a case, the cross elasticity of demand is zero. For example, a fall in the price of tea has no effect on the quantity demanded of car. Hence, the cross elasticity of demand for unrelated goods is zero. We may draw certain inferences from this analysis of the cross elasticity of demand. The cross elasticity between butter and jam may not be the same as the cross elasticity of jam to butter. It shows that in the first case the coefficient is 0. The superior the substitute whose price changes, the higher is the cross elasticity of demand. This rule also applies in the case of complementary goods. Generally, cross elasticity for substitutes is positive, but in exceptional circumstances it may also be negative. This distinction helps to define an industry. If some goods have high cross elasticity, it means that they are close substitutes. Firms producing them can be regarded as one industry. A good having a low cross elasticity in relation to other goods may be regarded a monopoly product and its manufacturing firm becomes an industry by determining the boundary of an industry. Thus cross elasticities are simply guidelines. Application of Cross Elasticity in Management: The cross elasticity of demand has much practical importance in the solution of various business problems: It is important for a firm to have knowledge of it while making its production plan. Its knowledge helps the firm in estimating the potential impact of the pricing decisions of its competitors and associates on its sales so that it prepares its pricing strategies. The utility of this concept is significant in the area of international trade and balance of payments. The government wants to know how the change in domestic prices affects the demand for imports. Income Elasticity of Demand: It may be defined as the ratio of percentage change in the quantity demanded commodity to the percentage change in income. The coefficient E may be positive, negative or zero depending upon the nature of a commodity. If an increase in income leads to an increased demand for a commodity, the income elasticity coefficient Ey is positive. On the other hand, if an increase in income leads to a fall in the demand for a commodity, its income elasticity coefficient Ey is negative. Normal goods are of three types: Income elasticity of demand is high when the demand for a commodity rises more than proportionate to the increase in income. Taking income on the vertical axis and the quantity demanded on the horizontal axis, the increase in demand Q1 income Q2 in more than the rise in income Y1, Y2 as shown in Fig 9. The curve Dy shows a positive and elastic income demand. Income elasticity of demand is low when the demand for a commodity rises less than proportionate to the rise in the income. The curve Dy in Figure 11 shows unitary income elasticity of demand. The increase in quantity demanded Q1 Q2 exactly equals the increase in income Y1Y2. In the case of inferior goods, the consumer will reduce his purchases of it, when his income increases. Figure 12 shows the Dy curve for inferior goods which bends upwards from A to when the quantity demanded decreases by good with the rise in income by Y1Y2. Figure 13 shows a vertical income demand curve Dy with zero elasticity. Measuring Income Elasticity of Demand: Each Dy curve expresses the income-quantity relationship. In Figure 9, we have explained income elasticity of demand with the help of linear Engle curves. Income elasticity in terms of non-linear Engel curves can be measured with the point formula. This shows that the income elasticity of E2 curve over much of its range is larger than zero but smaller than 1. In the backward-sloping range, draw a tangent GC at point C. Ey is negative and the commodity is an inferior good. But before it bends backward, the Engel curve E3 illustrates the case of a necessary good having income inelasticity over much of its range. Determinants of Income Elasticity of Demand: There are certain factors which determine the income elasticity of demand: The Nature of Commodity: Commodities are generally grouped into necessities, comforts and luxuries. This grouping of commodities depends upon the income level of a country. A car may be a necessity in a high-income country and a luxury in a poor low-income country. Income elasticity of demand depends on the time period. Over the long-run, the consumption patterns of the people may change with changes in income Page 4

5 with the result that a luxury today may become a necessity after the lapse of a few years. The demonstration effect also plays an important role in changing the tastes, preferences and choices of the people and hence the income elasticity of demand for different types of goods. The frequency of increase in income also determines income elasticity of demand for goods. If the frequency is greater, income elasticity will be high because there will be a general tendency to buy comforts and luxuries. Use of Income Elasticity in Business Decisions: The income elasticity of a product has great significance in long-term planning and in the solution of strategic problems, particularly during trade cycles: The knowledge of income elasticity of demand is very important for both the firms and the government. Firms whose demand function is income elastic, the scope of their growth is generally wide in an expanding economy but they are very insecure during recession. So such firms must consider their all economic activities and their potential growth rate in future. On the contrary, firms whose products are less income elastic, they will neither obtain more profit with the expansion of the economy nor will they incur specific loss during recession in the economy. Such firms consider it necessary to bring variety in different products or in a different industry. For example, agricultural products are less income elastic while industrial products are income elastic. Moreover, since the coefficient of income elasticity of inferior goods is negative, the sale of such products will decline with economic growth. In Formulation of Farm Policy: Hence, in the coming years the danger of such agricultural problems is likely to remain particularly in developing countries. Therefore, the Government of India has considered it necessary to continue and increase various agricultural subsidies. The concept of income elasticity can be used in forecasting future demand provided the firm knows the growth rate of income and income elasticity of demand for the good. It is often believed that the demand for goods and services increases with the rise in GNP that depends on the marginal propensity to consume. But it may be proved true in the context of aggregate national demand while it is not necessary to be true for a particular good. For this, the income of the related income class should be used. It is also useful for avoiding the problem of overproduction or under-production. In Formulating Marketing Strategies: For instance, the sales centers of ice creams will be located in the prosperous town areas where the people have sufficient income and their incomes are likely to increase sufficiently in future. Here, the expected rise in demand in the context of increased income has been discussed. But this rise will be compensated in more or less quantity by the expected fall in demand with the increase in price. Advertising or Promotional Elasticity of Demand: Under advertising, various visible or verbal activities are done by the firm for the purpose of creating or increasing demand for its goods or services. Informative advertising is very helpful for the consumer in making rational purchase decisions. But the extension of demand through advertising can be measured by advertising or promotional elasticity of demand EA which measures the expected changes in demand as a result of change in other promotional expenses. The demand for some goods is affected more by advertising such as the demand for cosmetics. The elasticity of demand for a good should be positive because there is the possibility of extension of demand and market for the good with advertising expenditure. The higher the value of this elasticity, the greater will be the inducement of the firm to advertise that product. It is on the basis of advertising elasticity that a firm decides how much to spend on advertising a product. Factors Influencing Advertising Elasticity of Demand: The main factors influencing advertising elasticity are as follows: The advertising elasticity of demand for a product may vary with different levels of sales of the same product. It is different for new and established products. The advertising effect in a competitive market is also determined by the relative effect of advertising by competing firms. Effects of Advertising in Terms of Time: The advertising elasticity of demand depends upon the time interval between advertising expenditure and its effect on sales. This depends on general economic environment, selected media and type of the product. This time interval is large for durable goods than for non-durable goods. Effect of Advertising by Rival Firms: The advertising elasticity also depends as to how other rival firms advertise in comparison to the advertisement of the firm. This, in turn, depends on the levels of advertisement and advertisements done in the past and present by rival firms. Importance of Elasticity of Demand in Management The elasticity of demand is of great importance in managerial decision making. Page 5

6 Chapter 5 : What are the types of Elasticity of Demand? - Business Jargons Price elasticity of demand and supply. How sensitive are things to change in price? Learn for free about math, art, computer programming, economics, physics, chemistry, biology, medicine, finance, history, and more. The degree to which demand or supply reacts to a change in price is called elasticity. Elasticity varies from product to product because some products may be more essential to the consumer than others. Demand for products that are considered necessities is less sensitive to price changes because consumers will still continue buying these products despite price increases. On the other hand, an increase in price of a good or service that is far less of a necessity will deter consumers because the opportunity cost of buying the product will become too high. A good or service is considered highly elastic if even a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life, or if there are good substitutes. For example, if the price of Coke rises, people may readily switch over to Pepsi. On the other hand, an inelastic good or service is one in which large changes in price produce only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life, such as gasoline. To determine the elasticity of the supply or demand of something, we can use this simple equation: If it is less than one, the curve is said to be inelastic. As we saw previously, the demand curve has a negative slope. If a large drop in the quantity demanded is accompanied by only a small increase in price, the demand curve will appear looks flatter, or more horizontal. People would rather stop consuming this product or switch to some alternative rather than pay a higher price. A flatter curve means that the good or service in question is quite elastic. Meanwhile, inelastic demand can be represented with a much steeper curve: Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one. The elasticity of supply works similarly to that of demand. Remember that the supply curve is upward sloping. If a small change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. The good in question is inelastic with regard to supply. This means that coffee is an elastic good because a small increase in price will cause a large decrease in demand as consumers start buying more tea instead of coffee. However, if the price of caffeine itself were to go up, we would probably see little change in the consumption of coffee or tea because there may be few good substitutes for caffeine. Most people in this case might not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product. While a specific product within an industry can be elastic due to the availability of substitutes, an entire industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes. Necessity As we saw above, if something is needed for survival or comfort, people will continue to pay higher prices for it. For example, people need to get to work or drive for any number of reasons. Therefore, even if the price of gas doubles or even triples, people will still need to fill up their tanks. Time The third influential factor is time. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. Income Elasticity of Demand Income elasticity of demand is the amount of income available to spend on goods and services. This also affects demand since it regulates how much people can spend in general. If there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand: It follows, then, that if there is an increase in income, demand in general tends to increase as well. If EDy is greater than 1, demand for the item is considered to have a high income elasticity. If EDy is less than 1, demand is considered to be income inelastic. As an example, consider what some consider a luxury good: With this new higher purchasing power, he decides that he can now afford to go on vacation twice a year instead of his previous once a year. With the following equation we can calculate income demand elasticity: With some goods and services, we may actually notice a decrease in demand as income increases. These cases often involve goods and services considered of inferior quality that will be dropped by a consumer who receives a salary increase. An example may be the decrease in going out Page 6

7 to fast food restaurants as income increases, which are generally considered to be of lower quality that other dining alternatives. Products for which the demand decreases as income increases have an income elasticity of less than zero. Products that witness no change in demand despite a change in income usually have an income elasticity of zero. These goods and services are considered necessities and are sometimes referred to as Giffin Goods. Another anomaly in elasticity occurs when the demand for something increases as its price rises. For example, designer label clothing or accessories or luxury car brands signal status and prestige. A work of art, a personal chef, or a diamond ring all may be in high demand precisely because they are expensive. These types of goods are referred to as Veblen Goods. Page 7

8 Chapter 6 : Price elasticity of demand - Wikipedia Price elasticity of demand is a measure used to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. Generally any change in price will have two effects: The effect is reversed for elastic goods. The quantity effect An increase in unit price will tend to lead to fewer units sold, while a decrease in unit price will tend to lead to more units sold. For inelastic goods, because of the inverse nature of the relationship between price and quantity demanded i. But in determining whether to increase or decrease prices, a firm needs to know what the net effect will be. Elasticity provides the answer: The percentage change in total revenue is approximately equal to the percentage change in quantity demanded plus the percentage change in price. One change will be positive, the other negative. As a result, the relationship between PED and total revenue can be described for any good: Goods necessary to survival can be classified here; a rational person will be willing to pay anything for a good if the alternative is death. For example, a person in the desert weak and dying of thirst would easily give all the money in his wallet, no matter how much, for a bottle of water if he would otherwise die. His demand is not contingent on the price. Hence, when the price is raised, the total revenue increases, and vice versa. Hence, when the price is raised, the total revenue falls, and vice versa. Hence, when the price is raised, the total revenue falls to zero. This situation is typical for goods that have their value defined by law such as fiat currency ; if a five-dollar bill were sold for anything more than five dollars, nobody would buy it, so demand is zero. Hence, as the accompanying diagram shows, total revenue is maximized at the combination of price and quantity demanded where the elasticity of demand is unitary. The linear demand curve in the accompanying diagram illustrates that changes in price also change the elasticity: Effect on tax incidence[ edit ] When demand is more inelastic than supply, consumers will bear a greater proportion of the tax burden than producers will. For example, when demand is perfectly inelastic, by definition consumers have no alternative to purchasing the good or service if the price increases, so the quantity demanded would remain constant. Hence, suppliers can increase the price by the full amount of the tax, and the consumer would end up paying the entirety. In the opposite case, when demand is perfectly elastic, by definition consumers have an infinite ability to switch to alternatives if the price increases, so they would stop buying the good or service in question completelyâ quantity demanded would fall to zero. As a result, firms cannot pass on any part of the tax by raising prices, so they would be forced to pay all of it themselves. More generally, then, the higher the elasticity of demand compared to PES, the heavier the burden on producers; conversely, the more inelastic the demand compared to PES, the heavier the burden on consumers. The general principle is that the party i. Optimal pricing[ edit ] Among the most common applications of price elasticity is to determine prices that maximize revenue or profit. Constant elasticity and optimal pricing[ edit ] If one point elasticity is used to model demand changes over a finite range of prices, elasticity is implicitly assumed constant with respect to price over the finite price range. The equation defining price elasticity for one product can be rewritten omitting secondary variables as a linear equation. Chapter 7 : Elasticity Microeconomics Economics and finance Khan Academy The elasticity of demand is a measure of how responsive quantity demanded is to a change in price. A demand curve is elastic when a change in price causes a big change in the quantity demanded. The opposite is true of inelastic curves. Chapter 8 : Price Elasticity of Demand (PED) Economics Help Elasticity is a term used a lot in economics to describe the way one thing changes in a given environment in response to another variable that has a changed value. For example, the quantity of a specific product sold each month changes in response to the manufacturer alters the product's price. Page 8

9 Chapter 9 : Price elasticity of demand In economics, elasticity is used to determine how changes in product demand and supply relate to changes in consumer income or the producer's price. To calculate this change, we can use the. Page 9