Main Factors Which Affect Price Elasticity Economics Essay

The companies in the market values the importance of profits as the effects of price changes directly relates to total revenue earned. Total revenue defines as the total amount of money earned by selling the product in a given time and it is also linked to price elasticity of demand. When there are changes in the total revenue which is opposite to the price, the demand is deemed elastic. If the total changes in the total revenue are the same directing of price, the demand is inelastic. While the total revenue is unchanged when price changes, this demand is unit-elastic (McConnell et al., 2009).

The availability of substitute is one of the main factors which affect price elasticity. The general rule of thumb is that if there are more substitute for any given product, the more elastic the demand will be. Taking an example like the price of coffee. When the price of coffee increases, consumers will then switch to drinking tea instead to get their daily dosage of caffeine, which will result in a large decrease in demand for coffee. This product is deemed to be an elastic product. On the contrary, if the price of caffeine is to increase, there will be no change in the consumption of coffee or tea and there is no or little substitute to caffeine. Consumers will still want to buy either coffee or tea no matter what the price of caffeine will be. Hence caffeine is considered and inelastic product due to its lack of substitute in the market. Another product deemed to be inelastic is diamonds. Because they have few and no substitutes (Investopedia, 2010)

The below graph shows the concept of inelastic demand curve;

* Data adapted from McConnell et al. (2009)

The inelastic graph above shows a steeper downward slope which means that there is little change in quantity when there is a large change in price.

* Data adapted from McConnell et al. (2009)

The above graph shows an elastic demand curve which displays a gentler gradient and almost horizontal downward slope. This depicts when there is a decrease in price, there will be a huge increase in demand.

(McConnell et al., 2009).

Retailers most of the time would like to adopt a business practice called “price skimming”. This practice allows the seller to set a higher price on a newly launched product to generate more revenue from customers who is eager to pay more for it for the purpose of using it earlier than others. The success of this practice will depend greatly on the inelasticity of demand of the product in the market. This form of practice usually reaps more monopoly profits for the seller during this short-term period. While there is a great increase in profits, other competitors will then be enticed to “hitch a ride” as well resulting in more competition. At the same time, the price of the product will decrease overtime when more “players” are in the same market.

There is much advantage in this form of practice as a form of recouping cost for fund used in research and development of the innovative product, advertising and promotion costs. In this way, the practice of price-skimming allows some returns on the set-up expenditure. By charging a high price initially, the main supplier will have the freedom to adjust the price when competition arrives. However, when the price is set too low initially, it will be difficult and not wise to increase the price as this will affect the loss in sales volume. With the high cost of the product, it sets the tone of having a superior-quality complexion over its rivals. This is especially true for the industry of “designer-label” clothing. The consumers in this market will be more brand conscious than price conscious, thus enabling them to spend more in regards to the price. In order words, the more expensive the product is, the more customers will want to buy it (Tutor2U, 2010).

This fully concludes that the seller’s intention to sell at a higher price is looking at high returns of revenue and profits. On another hand, seeking high returns will have to fully depend on the elasticity of the demand of the product and what strategy the company is going to adopt in order to achieve its strategic objectives.

Question: 1B

Demand refers to quantity of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand (Investopedia, 2010).

If there is a cut in supply of cars in Singapore, supply will shift leftwards from S to S2. Quantity of supply will drop from Qe to Q2. There will be a shortage of cars to deal with the current demand. As there are insufficient cars to meet the demand, suppliers will increase the price of the car to P2 (McConnell et al., 2009).

Demand and Supply Graph for Cars (Current Quarter)

* Data adapted from McConnell et al. (2009)

The degree to which a demand reacts to a change in price is call elasticity. Elasticity varies among products because some goods may be more essential to the consumer .As cars are luxury goods, the demand for it will depend on its price, consumer income and the presence other substitutes. Price increase of a good that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product will become too high. In the next quarter, the demand for cars will be foreseen to decrease due to its elastic demand (Investopedia, 2010).

Demand Elasticity Graph for Cars

* Data extracted from Investopedia (2010)

Car is considered to be elastic as a slight change in price leads to a sharp change in the quantity demanded. The demand curve looks flatter or more horizontal as substitutes are available and consumers may not necessarily need them in his or her daily life.

When price increases, the buying power of consumers will decrease as the amount of income available to spend on the car will decrease. For example, if the price of the car goes up from $500 to $800 (monthly installments) and income stays the same; the income that is available to spend on car will become more insufficient. The consumer is forced to reduce his or her demand on cars. With an increase in price and no change in the amount of income available to spend on the good, it will result in elastic reaction in demand (demand will be sensitive to a change in price)

In addition, Singapore has advanced transportation services. Consumers can easily switch to public transport if they cannot afford to get a car after the price increase (the more substitutes, the more elastic the demand will be). The higher prices will lead to consumers to cut back their purchase of cars. The demand will be is elastic, or sensitive to change because a raise in price will cause decrease in demand as consumers cuts down on car purchase and take more public transport instead (Investopedia, 2010).

To conclude, cut in supply of cars in Singapore will lead to an increase in price. However, due to higher price, limitation in income and high availability of substitute; demand will decreases in the next quarter.

(Word count: 1250)