A) Elasticity of demand can be defined as the sensitivity of demand to a change in price and it is calculated as a difference in the quantity demanded divided by the difference in price. Cross-price elasticity is the measure of responsiveness of the quantity demanded of a product to the change in price of another one. Complements, the products that are usually consumed together, have negative cross-price elasticity. Substitute goods, on the other hand, have positive cross-price elasticity, since consumers can easily replace one for the other. Income elasticity is the degree of responsiveness of the quantity demanded to the change in income. Income elasticity is usually negative for inferior goods, a type of goods that consumers demand less as their income rises. Unlike inferior goods, normal goods have positive income elasticity. This characteristic stems from the fact that consumers usually purchase more of normal goods as their income increases. Normal goods are further subdivided into luxury goods, with income elasticity above 1, and necessities, with income elasticity between 0 and 1. The former are purchased significantly more as income level rises due to their perceived prestige, while the consumption of the latter does not increase as much as the income. If income elastic of a product is equal to 0, then it is referred to as “sticky” due to the resistance to change of the demand for it (Mankiw, 2009).
B) Demand elasticity coefficient indicates demand responsiveness to price changes. The coefficient of demand elasticity equal to 1 shows that consumers change their demand by the percentage equal to the percentage change in price. The elasticity coefficient above 1 indicates an elastic demand, which means that demand changes by a higher percentage than the change in price. The elasticity coefficient below1 indicates inelastic demand. The cross-price elasticity coefficient below 0 shows that the demand for one good and the price for the other good change in the same direction. In this case the two products are complements. Alternatively, the two products are substitutes if their cross-price elasticity is positive. In case the coefficient is 0, there is no relation between the two goods. Lastly, income elasticity is the measure of demand responsiveness to income changes. Normal goods usually have income elasticity between 0 and 1, while income elasticity for inferior goods is negative. Highly positive income elasticity (above 1) usually characterizes luxury goods. Income elasticity is 0 for sticky goods, which enjoy the same level of demand despite the price change (Mankiw, 2009).
C) The concepts discussed above illustrate several different sensitivities. Demand elasticity shows how demand for a product reacts to price changes and can be helpful for in identifying the optimum pricing strategy that would maximize company’s revenues. Income elasticity demonstrates the responsiveness of demand to consumers’ income changes and helps in forecasting demand changes in response to the macro and microeconomic events that alter consumers’ income. Cross price elasticity relates the demand for one product to the price of the other. It is helpful in understanding the relation between the two products. This indicator shows whether the two products are substitutes, therefore they compete in the market for consumer preference, or whether that are complementary and the demand for one reinforces the demand for the other (Mankiw, 2009).
D) Availability of close substitutes makes demand more elastic as consumers can switch from more expensive to cheaper items. In this case the quantity demanded of the product will change even if the price changes by a small percentage. The degree of elasticity would depend on how close the substitute products are and how much consumers value the particular item as compared to its substitutes.
Large share of consumer income devoted to a good makes demand more elastic as people need a higher percentage of their income to purchase the item. This phenomenon can be explained by the fact that people pay more attention to the price of purchased items, when it takes a higher proportion of their income to acquire them. Thus, if only a small part of consumers’ income is used for the purchase, the effect of the price change on the income will not be significant; hence, the demand will be income inelastic.
There is also a positive correlation between consumer’s time horizon and demand elasticity. The more time consumers have to respond to the price change, the more opportunities they have to find substitutes or to change consumption patterns. Thus, in the long-run people can find substitutes in response to the change in price, therefore their demand becomes more elastic. In the short-run, however, people are unable to completely alter their consumption and there is a certain level of inertia that delays the response to the price change.
E) Train and plane tickets are considered close substitutes for short-distance trips, therefore the higher the prices for train tickets, the more willing customers travel by plane, as the benefits of shorter travelling time can no longer be realized (especially due to airport security procedures, travelling to the airport etc.). This fact should be closely considered by the airline companies in developing their pricing strategy. Thus, on short-distance trips it is important to offer lower prices not only compared to other airlines but also in relation to railroad companies or even in comparison with travelling by car.
Real estate purchases usually represents a high proportion of income, therefore people are sensitive to price changes and take time to find cheaper alternatives. Instead, purchasing basic food items requires only a small part of income, therefore price changes usually do not have a significant impact on demand. The implications of this fact are quite significant. In the first case real estate companies should pay careful attention to the market trends and ensure price stability (at least in the short-run) even if a price increase is expected, since consumers may decrease their consumption dramatically in response to the change in price. Instead, basic food producers can adjust prices if needed (e.g. if input costs increase) as their customers will not react to the change in price significantly.
As time horizon affects demand elasticity an increase in price for public transportation will have little impact in the short-run. In the long-run, however, people will look for other alternatives, such as travelling by car or walking. Therefore, even though transport companies can afford raising prices, they have to consider the long-term effect on the demand and predict that demand is likely to gradually decline in the future. In order to avoid losing customers, the new price level should be benchmarked against the price for substitute products.
F) Demand is perfectly inelastic if there is no change in quantity demanded in response to the change in price. It is represented by a vertical line. Demand is perfectly elastic if even a small price increase makes it equal to zero. Perfectly elastic demand can be illustrated by a horizontal line.
G) The effect of demand elasticity on the total revenue is depicted by the two graphs below. The revenue curve shows the earnings that are obtained by multiplying price by the quantity of the product demanded at the respective price level. In the elastic range a small decrease in price results in a greater increase in demand, therefore there is an overall positive effect on total revenues. Thus, if the quantity increases by 400% from 1 to 5 and the corresponding price decreases by 50% from 80 to 40, price elasticity will be equal to 400% / (-50%) = -8, indicating elastic demand. Total revenue in this case increases from 80 to 200.
The unit elasticity point corresponds to the maximum total revenue level of 200. At this point total revenues neither decrease nor increase as the price changes, since the quantity demanded of the product changes proportionally.
In the inelastic range of the demand curve, prices lowering prices would only decrease revenues as the demand will increase by a smaller percentage. For example, as the price falls by 100%, from 40 to 0, the quantity demanded only increases by 80%, which corresponds to a change from 5 to 9 and a decline in revenue from 200 to 0. Based on this values, demand elasticity in this range is equal to 80%/(-100%) = -0.8%, which corresponds to inelastic demand.
