1. Elasticity of demand 4
2.Price elasticity of demand 5
3.Income Elasticity of Demand 8
4.Cross -Price Elasticity of demand 12
5. Estimating and Forecarting The U.S. Demand for Elasticity 14
Suppose, the consumer is purchasing two commodities whose prices and income are then the demand functions of the consumer for two commodities is derived from the principle of utility maximisation. So, the demand for each commodity will be the function of all prices and the level of income(Salvatore, 2003, pg 127). For example, the amount of two commodities are q1 and q2 , p1 and p2 are their respective price and if y is the income of the consumer then the two demand function will be written as
q1= q1(p1,p2,y)
And q2= q2 (p1,p2,y)
Then,
The demand for any commodity changes when the price if that commodity , price of any other commodity changes and the income of the consumer changes. So the percentage of the quantity demanded due to one percent change in any of these independent variables is called the elasticity of demand. There are two types of elasticities price elasticity and income elasticity. But price elasticity of demand is divided into direct or own price elasticity and cross price elasticity(Salvatore, 2003, pg 128).
Price elasticity of demand
Price elasticity of demand measures the responsiveness in the quantity demanded of a commodity to a change in the price of that commodity(Salvatore, 2003, pg 133). This could be measured by the inverse slope of the demand curve. The disadvantage is that the inverse of slope is expressed in terms of the units of measurement. The price elasticity of demand is given by the change in quantity demanded of a commodity divided by the one percent change in its price. It is measures the point elasticity of demand at a particular point on the demand curve( Salvatore,2003, pg133).
Price elasticity of Demand = ΔQ/ΔP.P/Q where ΔQ= change in quantity demanded and ΔP = change in price
Q= quantity demanded and P= price of the commodity( Salvatore, 2003,pg133). If the price elasticity is equal to 1 then it is unit elastic, it means that change in price is equal to the change in quantity demanded. If the elasticity likes between 0 and 1 then it is relatively inelastic i.e huge change in demand will cause small change in price. If the elasticity is equal to zero then it is perfectly inelastic it means that change in price will have no change in quantity demanded(Salvatore, 2003, pg 134).
The first row of table shows that the price elasticity of demand for clothing in the United States is -0.90 in the short run but rise to -2.90 in the long run. That, means that1% increase in price leads to the reduction in the quantity demanded of clothing of only 0.9% in the short run and 2.90% in the long run. Although the price elasticity for gasoline is three times higher in the long run than in the short run..It means that people cannot find the suitable substitutes for gasoline in the long run. The table shows the short run and the long run price elasticity of demand for a selected list of other commodities. The estimated price elasticity for any commodity is likely to vary depending on the nation under consideration, the time period examined and the estimation technique used. Thus the estimated price elasticity values should be used with caution . many economic policies ( such as American dependence on imported petroleum) rely crucially on price elasticises. For example with the price of gasoline of about $1.50 per gallon and a short run price elasticity of 0.2(given in the table below) , a $0.50 tax per gallon would increase the price of gasoline from $1.50 to $2.00 per gallon , or about 33% and reduce the quantity demand of gasoline by 6.6% in the short run. When the price elasticity is equal to 0.6 in the long run the reduction in the quantity demanded of gasoline would still be about only 20%(Salvatore, 2003,pg135).
Income Elasticity of Demand
If all the prices are assumed to remain constant while income is variable then as income changes prices remaining the same there will be income effect and the quantity demanded will also change. This is known as income elasticity of demand.
Income elasticity and Engel curve shows the amount of a commodity that a consumer would purchase per unit at various income level while holding the prices and tastes constant(Salvatore, 2003,pg 136). Then the responsiveness of the quantity demanded of a commodity at any point on the Engel curve by income elasticity of demand.
is defined as = ΔQ/ΔI.I/Q where ΔQ= change in quantity demanded and ΔI = change in income
Q is the quantity demanded and I is the income.
A commodity is normal if the income elasticity is positive and inferior if the income elasticity ifs negative. A normal good is classified as necessity if income elasticity is less than one and as luxury if the income elasticity is greater than 1. In real world , food , clothing, housing ,healthcare normal goods, Inferior goods are generally the inexpensive goods whose substitutes are available. In normal goods, food and clothing are necessity and education , recreation are luxury(Salvatore, 2003, pg136).
Third and last rows of the Table shows that respectively that income elasticity of demand is 1.91 for transatlantic air travel and -0.36 for flour. This means that a 1% increase in the consumers income can lead to a 1.91% increase in expenditures on foreign travel but to 0.36% reduction of expenditure on flour. Thus foreign travel is a luxury while flour is a inferior good. The table shows wine is also luxury but cigarettes , beer ,are necessities. So income elasticity is measured in the table as the percentage changed in the expenditures on various commodities to the extent that the prices are constant the we get the same results(Salvatore,2003,pg137).
Cross Price Elasticity
We know that when one thing is held constant in drawing the market demand curve for a commodity is the price of substitutes and complimentary commodities. For example consumer purchases more coffee when the price of tea rises. The and coffee are substitutes. On the other hand if two commodities X and Y are complements if the less of X is purchased when the price of Y goes up. Like lemon and tea are complements, coffee and cream, hamburgers and buns..So the responsiveness in the quantity demanded of commodity X as a result in the change in the price of commodity Y is the cross price elasticity of demand(Salvatore, 2003, pg 138).
Cross price elasticity= ΔQX/ΔPY.PY/QX where ΔQX is the change in quantity purchased of x, ΔPY is the change in the price of Y, PY is the original price and QX is the original quantity of X.
For example, a change in the price of coffee will affect on the quantity of sugar( a complement of coffee) demanded . The cross price elasticity of demand between Chevrolets and Ford is very high as they belong to the same auto industry . But this is the entire market response so for an individual consumer the example is given below.
The first row shows the cross price elasticity of demand of margarine with respect of butter. This means that a 1% increase in the price of butter leads to 1.53 % increase in the demand for margarine. On the other hand the last row of the table shows that the cross price elasticity of cereals with respect to fish is -0.87. this means that 1% increase in the price of cereals leads to a reduction in the demand for fresh fish by 0.87%. Thus, cereals and fresh fish are complements. It also shows the cross price elasticity of demand of other commodities in United States( Salvatore,2003).
Estimating and Forecasting the U.S. Demand for Electricity
It is important to estimate and forecast the demand for electricity in order to build new capacity of future needs. One such estimate was provided by Halvorsen . he used multiple regression analysis to estimate the market demand for Electricity. The table shows the estimated elasticity of demand for electricity for residential use in the United states with respect to the price of electricity, per capita income, the price of gas and the number of consumers in the market. Though results vary but the results reported below indicate that the amount of electricity for residential use consumed in the United states would fall by 9.74% as a result of a 10% increase in price of electricity, would increase by 7.14% with a 10% increase in per capita income , would increase by 1.59% with a 10% increase in the price of gas, and is proportional to the number of consumers in the market. So the market demand curve for electricity is negatively sloped , electricity is a normal good and a necessity and gas is a substitute for electricity. Using the above estimated demand elasticities and projecting the growth in per capita income, in the price of gas , in the number of customers in the market, in the price of electricity, public utilities could forecast the growth in the demand for electricity in the United States as to adequately plan new capacities to meet future needs. For example if we assume that per capita income grows at 3% per year, the price of gas at 20% per year , the number of customers at 1% per year, the price elasticity of demand at 4% per year we can forecast the demand for electricity for residential use in that United states will expand at the rate of 2.43% per year(Salvatore,2003, pg157). The rate is obtained by adding the products of the value of each elasticity to the projected growth of the corresponding variable as shown below:
Q = (0.714)(3%) + (0.159)(20%) + (1.0000)(1%) – (0.974)(4%)
= 2.142 + 3.180 + 1.0000 – 3.896
= 6.322 - 3.896 = 2.426
With different projections of the yearly growth in per capita income, the price of the gas, the number of customers in the market and the price of electricity we will get the corresponding results.
The price of electricity to remain constant the demand for electricity would rise by 6.322% per year . the projected increase in the price of electricity by 4% per year will result in a decline in the quantity demanded of electricity by 3.896% > the net result of all the forces gives rise to a net increase of 2.426% per year.
Until the mid 190's when the deregulation of the electricity market started in the United States the nation's regulatory commissions set low electricity rates and this discouraged the building of new power plants. Electrical power companies simply preferred charging higher electricity rates at times of peak demand rather than building new plants. All this began to change during the past decade as the electricity market started to be regulated. Botched up deregulation however led to widespread electricity shortages, blackouts or brownouts, and sharply higher prices in California and other western states during 2000 and 2001 and this slowed down, put on hold, or ever reversed the deregulation process. The united States does need to build from 1,300 to 1,900 new power plants to meet future demand , which is expected to grow by 45% by the year 2020( Salvatore,2003, 158).
Reference List
Salvatore, Dominick. "Microeconomic-Theory and Applications"(2003). Oxford University Press.
"Value Networks- The Future of the U.S Electric Utility Industry" Sloan Management Review, Summer 1997, (pp 21-34)
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