Explain The Concept Of Elasticity Of Demand Economics Essay

There are generally three types of elasticity of demand, which are price, cross-price and income elasticity of demand. These three will be explained individually in order in the following paragraphs.

Price elasticity of demand is a measure of the responsiveness of change in quantity demanded of a good/service to a change in price, ceteris paribus. As the law of demand indicates, when the price of a good/service increases, the demand of it will decrease. Conversely, when the price of a product decreases, the demand of the product will increase. However, the extent to which a price change impacts the demand differs widely from produce to product. PED=(change in quantity demanded)/(change in price). If this value is bigger than one, the product is said to be price elastic (price sensitive), whereby a change in price will lead to a greater than proportionate change in quantity demanded. If the PED is smaller than one, the product will be price inelastic (price insensitive), where a percentage change in price will lead to a smaller percentage change in quantity demanded. And when PED=1, the product is unit elastic, where an X% change in price will result in an X% change in quantity demanded.

One of the factors that affect the PED is the substitutes and complementary product that a good/service has. And cross-price elasticity of demand measures the responsiveness of demand for good X following a change in the price of a related good Y.

For complementary goods, the two goods are in joint demand. That is, the relationship between the price of good Y and quantity demanded for good X will look like a normal demand curve. Goods in joint demand are closely related, and the stronger the relationship between two products, the higher cross-price elasticity of demand will be. A good example would be games and game consoles, as one cannot function without another. And as the price of one increase, the quantity demanded for the complementary good will decrease like any other normal goods due to joint demand, and vice versa. On the otehr hand, with substitute goods such as several competing brands of bread, an increase in the price of one good will lead to an increase in demand for the rival product, as consumers will likely switch to the cheaper product. And conversely a decrease in price of one good will lead to a decrease in demand for the rival product. However when consumers become regular purchasers of a product (effect of brand loyalty), the cross price elasticity of demand against rival products will decrease. This reduces the substitution effect that causes consumers to swicth to another product when an increase in price occurs, which makes demand less sensitive to price. The result is that firms will potentially be able to charge a higher price, increase total revenue and achieve higher profits.

Lastly there’s the income elasticity of demand. Another factor that can affect PED would be the price of a good relative to a proportion of one’s disposable income; so as one’s income changes, the price of the good in terms of a percentage of one’s income will change, thus affecting quantity demanded. Income elasticity of demand measures the relationship between a change in quantity demanded for a good and a change in real income.  The income elasticity is calculated by (% change in demand)/(% change in income). For normal goods, as consumers’ income rises, the quantity demanded will rise. Necessities such as food will have a Income Elasticity of Demand smaller than 1 (whereby a change in income will bring about a less than proportionate change in quantity demanded) and luxury goods such as TV sets will have a Income Elasticty of Demand bigger than 1 (whereby a change in income will bring about a more than proportionate change in quantity demanded). However for inferior goods as consumers’ income rises quantity demanded will decrease. Potential examples of inferior goods (this occurs only when there are superior goods available, and only if consumers can afford them) include the demand for low-price foods, cigarettes and alcohol.

Discuss why it may be important for a firm to have knowledge of price elasticity of demand:

The concept of PED generally help firms decide whether to raise or drop the price of their product in order to maximize revenue. For example, when the PED of a good is inelastic, it would be best to increase the price to maximize revenue; and when the PED is elastic, it’d be best to decrease the price to maximize revenue. However this is only a general idea, and simple PED does not take into account of the firm’s costs, rivalry/substitute goods, etc. The graphs belows shows the effect on revenue with a change in price for price elastic and price inelastic goods respectively.

However, firms need to know their product’s PED in order to alter prices; but how would they know a product’s PED? That’s when knowledge of PED is needed. Firms would first need to know some factors that may affect PED, and then use that information to evaluate the approxiamte PED of a product. For example, a firm can estimate PED for a product depending on the number of substitutes that exist in the market. The more substitutes in the market, the more elasticthe demand for a product is, because consumers can more easily switch their demand if price of one particular product changes. Firms can also assume the PED of a product by having an idea about the degree of necessity of that particular good/service. Products such as food (bread, rice), or even habitual products such as cigarretes are necessities and tend to have an inelastic demand whereas luxury goods such as TVs will tend to have a much more elastic demand because consumers can make do without these luxuries when their budgets are limited. Lastly, the firm need to know how cheap their product in terms of a proportion of the consumer’s income. Goods and services that take up a small proportion of a household’s income will tend to have an inelastic demand, as a price% rise in that product will make almost no difference for consumers. For example if a newspaper’s price increased from $1.00 to $1.10, very little people will fuss over this 10% (seemingly large percentage increase) increase in price because it is so insignificant compared to their income, and thus its demand is insentive to price change. So in short, producers need to have sufficient knowledge of PED to determine the PED of their product, which will in turn help them to set prices that can potentially maximize their revenue.

Furthermore, PED may help firms to set their policy on price discrimination. The firms will most likely be monopoly suppliers, and may decides to charge different prices for the same product to different segments of the market. Examples of this can be increase in price for peak-hour public transportation, more charge for hotel rooms during public holidays, because the products/services during those time periods have an inelastic demand; or vice versa, firms may decrease the price when the product/service is price elastic, such as unsold plane tickets the week before flight, or out-of-season clothes that won’t sell in a clothing store. This concept can actually also be linked back to basic knowledge of the PED, because the time period at which the product is sold is also a factor that can determine the PED of a product.

More specifically, concept and knowledge of PED can be applied in some tricky situations: for example, when government imposes indirect taxes on certian products that one firm produces. In this situation, knowing how price elastic the demand of the product is will help the firm to decided whether it is able to pass on the tax (or some of it) onto the consumers. If it’s goods like cigarretes which has an inelastic PED due to its habitual nature, it’s likely that firms may decide to pass the tax onto consumers as it will result in only a small decrease in quantity demanded. On the other hand, if it’s a luxury good such as cars, the firm may decide to not pass any of the tax onto consumers due to the the product’s elastic demand, because an increase in price can potentially decrease total revenue for a price elastic good, as shown in diagram before.

In conclusion, knowldge of PED is very important becaue firms need it in order to determine the PED of products, which then in turn help them to estimate and predict the effect of a change in price on the total revenue.