Fundamentals of Economics, Globe Business
A)
Elasticity of demand refers to the sensitivity of the demand for a product to a change in price. It is measured as a ratio of the change of the quantity demanded to the change in price (Demand elasticity).
Cross-price elasticity of demand measures the sensitivity of the quantity demanded of one good to the change in price change for another good. Negative cross-price elasticity indicates that the two goods are complements, therefore they are usually consumed together and a decrease/increase in the price for one will increase/decrease the quantity demanded of the other. Positive cross-price elasticity suggests that the products are substitutes, hence they can replace each other in consumption and the quantity demanded for one product increases with the increase of price for its substitute.
Income elasticity of demand refers to the rate of response of quantity demand to the change in a consumer’s income. Negative income-elasticity coefficient is associated with inferior goods, a special type of goods, the quantity demanded of which decreases as the income rises. Positive income-elasticity indicates normal goods, the products which are demanded more as consumers’ income increases. Goods with income elasticity between 0 and 1 are referred to as necessities, the products which require a smaller proportion of the income, as the income level rises. Income elasticity above 1 usually indicates luxury goods, the products which are not essential and are consumed as an indicator of wealth. Zero income elasticity indicates no change of the quantity demanded due to the change in price and it is associated with sticky goods, or the goods resistant to change (Mankiw, 2009).
B)
The coefficient of demand elasticity shows how sensitive consumers are to price changes. If the elasticity of demand coefficient is above one, then the demand is considered elastic. If it is equal to 1, the demand is called unit elastic. If the coefficient of elasticity is less than 1, then the demand is considered inelastic Moreover, the higher the coefficient, the fewer products consumers are willing to buy, when the price increases. However, when the price for a good decreases, consumers tend to buy more of it. Low price elasticity coefficient implies that price changes have little impact on the quantity demanded (Demand elasticity).
Cross-price elasticity of demand is usually compared to 0. If the coefficient is less than 0, the demand for one good changes in the same direction as the price for the other one. This dependence indicates that the two goods are complements. If the cross-price elasticity is 0, then there is no relationship between the two goods, therefore they are independent. If the coefficient is more than 0, the two goods are substitutes.
Income elasticity of demand measures demand sensitivity to an income change. If the income elasticity is between 1 and 0, the good is considered a normal good. If the income elasticity is below zero, then the good is an inferior good and consumers are willing to buy less of it as their incomes increase. Product with the income elasticity of demand above 1 are highly income-elastic and are usually referred to as luxury goods.
C)
The elasticity of demand shows the change in demand for a product in response to a change in price. Instead, income elasticity measures the sensitivity of demand to a change in consumer spending power. Cross price elasticity, on the other hand, provides the comparison of one product to the other. It is computed as a ratio of the percentage change of demand for one good to the percentage change in price of another good (Mankiw, 2009).
D & E)
If there are close substitutes for a product, buyers can easily shift from more expensive items to cheaper ones, therefore demand tends to be elastic. Thus, pasta and rice are often considered close substitutes. As corn prices increase, consumers are likely to demand more rice. Understanding this tendency is important for making business decisions. In the presence of close substitutes, companies should consider reducing their prices, which would result in the increase of the quantity demanded. Due to the elastic nature of the demand, the total revenue will increase, despite the price reduction, as it will be explained in section G. However, in the long-run it would be wise to consider differentiation from the competitors in order to reduce the number of close substitutes and not to engage in price wars, which decrease profitability and squeeze margins.
The larger the income proportion devoted to the product, the more elastic the demand for it is. This fact can be explained by the tendency of people to pay more attention to the cost of products, when a higher percentage of their income is used to purchase them. If a product requires only a small proportion of consumers’ budget, the income effect of the change in price will not be apparent, therefore, the demand for it will be inelastic. Thus, since the cost of plane tickets usually represents quite a high proportion of consumers’ income, people tend to search for cheaper alternatives among substitute products. On the other hand, people use only a small part of their income for purchasing bread, therefore, they usually do not significantly change the amount of bread purchased in response the increase in prices. Although business decisions cannot be based solely on the share of consumer income devoted to a good and has to consider other aspects, such as competition, market dynamics etc., the general suggestion is to reduce prices, when a high proportion of consumers’ incomes is dedicated to the product. Due to high demand elasticity price reduction will lead to an increase in the quantity demanded that would result in higher revenues. If consumers spend only a small share of their income on the product, their demand is inelastic, therefore a price raise will not decrease the quantity demanded substantially, and the total revenue of the company will increase.
Price elasticity also changes with the time horizon. The more time consumers have to respond to a change in price, the easier it is for them to find substitutes. Therefore, the demand in the long-run tends to be more elastic. Thus, with the increase in price in a particular restaurant people continue to go there in the short-run, however, in the long-run they can find cheaper restaurants in the neighborhood or switch to cooking at home. This fact also has implications for businesses. Thus, in the short-run it may be wise to charge higher prices, thus increasing total revenues due to the inelastic nature of the demand. However, in the long-run it is important to consider the prices offered by the rivals, in order to stay competitive and not to lose revenues once the demand becomes more elastic over time, and consumers find substitute products.
F)
Demand is considered perfectly inelastic if the quantity demanded is unaffected by any change in price. Demand is perfectly inelastic when buyers have no substitutes for a particular product. Perfectly inelastic demand is represented by a vertical line.
Demand is considered perfectly elastic when a small change in the price of a good brings the quantity demanded to zero. Perfect elasticity indicates that individual producers cannot sell their products at a price above the market one. If any producer tries to charge more, no one would buy his product. The graph for a perfectly elastic demand is a straight horizontal line.
Perfect inelastic demand
Perfect elastic demand
G)
The relationship between demand elasticity and total revenue can be illustrated by the two graphs above. The top part of the demand curve is elastic; the lower part is inelastic. The point where the rate of change of the quantity demanded is equal to that of the price represents unit elasticity. The corresponding revenue curve is obtained by multiplying the quantity of the product demanded at all price levels by the respective price.
For instance, the quantity of 3 corresponds to the price of 60, thus the total revenue is equal to 180. The shape of the curve is connected to the price elasticity of demand along the demand curve. In the relatively elastic range of the demand curve, a decrease in prices generates even greater increase in the quantity demanded, therefore total revenue increases. It corresponds to the quantity increase approximately from 1 to 4 (300%) and a price decrease from 80 to 50 (-37.5%), which indicates an elastic demand with price elasticity of -8, which generates the total revenue increase from 80 to 200.
In the inelastic range of the demand curve, however, lowering prices decreases total revenues, since the quantity demanded rises only moderately. With the price decreasing from 40 to 0 (-100%), the quantity demanded increases by only from 5 to 9 (80%), therefore demand elasticity is equal to -0.8% and shows inelastic demand. The associated revenue falls from 200 to 0. The peak of the total revenue curve at 200 corresponds to the point of unit elasticity at the price of 4.5 (exact midpoint of the demand curve), where total revenues are neither rising nor falling with the change in price, since the quantity demanded changes proportionally. The unit elastic range can be identified between the quantities equal to 4 and 5, which correspond to the prices 50 and 40 respectively. Both points generate the maximum total revenue of 4*50 = 5*40 = 200.
References
Demand elasticity. In Investopedia Retrieved from http://www.investopedia.com/terms/d/demand-elasticity.asp
Mankiw, G. (2009). Principles of economics. (6th ed ed., pp. 90-95). Mason, OH:
South-Western Cengage Learning.
