Price elasticity of demand and supply

EXECUTIVE SUMMARY

This assignment will examine one of the most important concepts in the whole of economics – elasticity. It is the responsiveness of one variable (demand or supply) to a change in another (e.g. price). This concept is elementary to comprehending how markets work. The most common elasticities used include price elasticity of demand, price elasticity of supply, cross-price elasticity of demand and income elasticity of demand.

The economic measures of how much the quantity demanded changes when the price changes is called price elasticity of demand. This response can be calculated by divided the percentage in quantity by the percentrage change in price. It is always end up negative. Determinants that affect price elasticity of demand include the number and closeness of substitute goods, the proportion of income spent on the good and the time period. They are directly related to the elasticity coefficient. Price elasticity of supply is a measure of how much the quantity supplied changes when the price changes. It is the ratio of the percentage change in quantity supplied to the percentage change in price. It is usually positive. Supply is determined whether elastic or inelastic depends on two main determinants: the ability of sellers to change the amount of the good they produce when the price changes and the time period.

Price elasticity can be used to predict the effect of a change in price on the total revenue and expenditure on a product or the effect of a change in a gorvernment indirect tax on price and quantity demanded.

Income elasticity of demand measures the rate of response of quantity demanded due to a raise (or lowering) in consumers income. It will be more elastic the more luxurious the good and the less demand is fulfilled as consumption increases. It is an important concept to firms considering the future size of the market for their product.

Finally, the assignment will study the case of demand for cigarettes in Vietnam and the ways are being considered to reduce the number of people smoking from elasticity point of view.

I. INTRODUCTION

A shoe shop decided to have a sale. It sells more shoes but take in less money per pair sold. Will it gain or lose revenue form the sale? How does a business determine whether to increase the price of the product it sells in order to increase revenues? Those questions relate to how responsive consumers are to price changes involves one of the most important concepts in economic theory – elasticity. It is a measure of responsiveness, a point to which a demand or supply curve reacts to a change in price. Understanding elasticity concept is useful and essential in comprehending an extremely wide range of applications in economics such as the incidence of taxation, welfare distribution or especially, the response of supply and demand in a market. The common elasticities used include price elasticity of demand, price elasticity of supply and income elasticity of demand will be discussed more details below.

II. ELASTICITY

To determine the elasticity of the supply or demand curves, this equation can be used:

Elasticity = % change in quantity / % change in price

Elasticity varies among products due to different level of neccessities among products may be to the consumers. A product is considered to be elastic if a change in price leads to a change in the quantity demanded or supplied. Normally, these kinds of products are easily available in the market and people may not need them very much in their daily life. On the other hand, an inelastic product is one in which changes in price only cause slight changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are extremely essential to consumers in their daily life.

III. PRICE ELASTICITY OF DEMAND

If a woman was about to have beef for lunch and were informed by the vendor that the price of it has been increased by 10,000 VND due to the rise if feed cost and low supply. Would she still buy beef for lunch? Given that her motorcycle has run out of gas, as she reached the gas station, she saw the price of it has risen by 450 VND per litre. Does she still gas up? The answers to these questions may closely relate to the price elasticity of demand.

1. Definiton

Price elastic of demand reflects the responsiveness of quantity demanded for a product when its price changes (Sloman, 2007).

2. Measuring the price elasticity of demand

Price elasticity of demand can be measured by divided the percentage change in quantity by the percentage change in price (Sloman, 2007):

ed = % change in quantity demanded / % change in price

3. Interpreting the figure for demand elasticity

The demand curves generally have downward sloping movement as a rise in price will lead to a fall in quantity demanded and vice versa. Then when measuring the price elasticity of demand, a negative figure is always divided by a positive figure and vice versa. Therefore, the price elasticity of demand is always end up negative.

Demand is elastic if the percentage change in quantity demanded is greater than the percentage change in price (ed > 1), unit elastic if both is equal (ed = 1), inelastic if the percentage change in quantity demanded is less than the percentage change in price (ed>1). In addition, there are two more extreme cases [1] : perfectly elastic in which a demand curve is horizontal and shows that percentage change in quantity demanded is infinite in relation to the percentage change in price (ed = ∞); perfectly inelastic shows a condition in which the quantity demanded does not change as the price changes (ed = 0).

4. Determinants of price elasticity of demand

There are several factors that affect the price elasticity of demand of certain goods. Returning to the example above, many people would not buy beef but switch to another meat such as chicken, pork or fish (or do not buy anymore) if prices increased by 10,000 VND. However, they undoubtedly would still fill up their motorcycle with gas even if the price were increased by 450 VND per litre. That is because meat and gasoline have very different price elasticity due to variety determinants.

First, the number and closeness of substitute goods [2] . The more alternatives a good has, and the closer they are, the more choices people will have when the price of the good increase. Therefore, the price elasticity of demand will be higher like the example of meat and gasoline above. The demand of meat is elastic as it has many substitutes but gas has no close substitute so its demand is inelastic.

Next, the proportion of income spent on the good [3] . If the good consumes a relatively big proportion of people’s income, price changes will considerably affect the amount people buy. For example, a person have to pay a quite large amount of his money for electricity bill, if the price increase of 50 percent (say it can get to 1,500 VND per one kilowatt electricity), probably it would affect the quantity used greatly. He can be forced to cut back the electricity used in month.

Time period is also a vital determinant in price elasticity of demand [4] . In the short run, people may have no choice but accept price changes. However, in the long run, they can adjust their consumption in the best effective ways. Take examples of gasoline again. Demand of it at the moment is high inelastic because people still have to drive their vehicles. With time, as the gas price remains higher, new fuel-efficient motorcycles or cares can be innovated for people or they can move closer to work.

5. Elasticity of demand and total revenue

Total consumer expenditure (TE) is another vital applications of price elasticity of demand. It will be the same as total revenue (TR) received by companies before deducting expenses. Perhaps the simplest way to tell whether demand is elastic, unitary elastic or inelastic is to observe the response of total revenue as the price of a product changes (Layton, et al., 2005). The diagrams below show different demand curves of price elasticity and the effect on a change in the market price.

According to Sloman (2007, pp. 60), when demand is inelastic, an increase in price leads to a rise in total expenditure of consumers for that good and thus an increase in the total revenue that the company receives and vice versa.

When demand is elastic – a decrease in price leads to a rise in total expenditure of consumers for that good, hence, the company total revenue will go up and vice versa.

When demand is unitary elastic, neither a rise nor fall in price affects the total expenditure of consumers for that good, thus, total revenue of the company remains unchanged.

IV. PRICE ELASTICITY OF SUPPLY

The changes in price do not only affect the quantity demanded but also the quantity supplied. Therefore, it is also useful to know how responsiveness of quantity supplied to a change in price by the measure of price elasticity of supply.

1. Definition

Price elasticity of supply is the responsiveness of quantity supplied to a change in price (Sloman, 2007).

2. Measuring the price elasticity of supply

Layton, et al. (2005, pp.133) shown that price elasticity of supply is measured as the ratio of the percentage change in the quantity supplied of a product to the percentage change in its price:

es = % change in quantity supplied / % change in price

3. Interpreting the figure for supply elasticity

The price elasticity of supply is usually positive because the quantity producers are willing to supply is directly related to price. The larger the price elasticity of supply, the more responsive the firms that supply the good or service are to a price change. Supply is elastic if the price elasticity of supply is greater than 1 (es > 1), unit elastic if it is equal to 1 (es = 1), inelastic if it is less than 1 (es < 1), perfectly elastic when a small change in price changes the quantity supplied by an infinite amount (es = ∞) and perfectly inelastic when the quantity supplied is unaffected by a change in price (es = 0).

4. Determinants of price elasticity of supply

Supply is whether elastic or inelastic depends on two main determinants. First, it depends on the ability of sellers to change the amount of the good they produce when the price changes. If the marginal cost to produce one more unit is extremely high as output increases, then a rise in price causes little increase in quantity supplied and supply is likely to be inelastic. However, if the marginal cost is low as output rises, it will induce a significant increase in quantity supplied. Time is another determinants which plays an important role in the price elasticity of supply. McEachern (2009, pp.111) stated that supply becomes more elastic over time as producers adjust to price changes. The longer the period for adjustment, the higher the supply responses. For instances, suppliers of gasoline, electricity…have slower response time as expansion of those products may take many years rather than suppliers of raincoat vending, house-cleaning service…as their expansion may take only days.

V. INCOME ELASTICITY OF DEMAND

John Sloman (2007, p.65) stated that “in practice, there are just two other elasticities that are useful and both are demand elasticities”. They are cross-price elasticity of demand and income elasticity of demand. In this assignment, only income elasticity of demand will be discussed.

Income elasticity of demand

Income elasticity of demand is the measure of the responsiveness of the quantity demanded to a change in consumer income. In particular, it is the ratio of the percentage change in quantity demanded of a good to a given percentage change in income [5] :

ey = % change in quantity demanded / % change in income

The major determinant of income elasticity of demand is the degree of the “neccessity” of the good (Sloman, 2007). For a normal good or service, income elasticity of demand is positive (ey > 0). Those are goods or services whose demand increases as consumer incomes increase (clothes, shoes, mobile phones, movies…). Luxury goods (Mercedes Benz S-class, Armani, jewelry…) will have a higher income elasticity of demand than basis goods. A positive ey suggests that when consumers income goes up, they will buy a great deal more of that good.

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For an inferior good or service, income elasticity of demand is negative (ey < 0). Those are goods or services whose demand decreases as consumer incomes increase (second-hand cars, instant noodles, canned food…). It implies just the opposite that when consumers’ income increase, they will buy great deal less of that good. Income elasticity of demand is an important concept to firms considering the future size of the market for their product (Sloman, 2007). If the product has a high income elasticity of demand, sale are probably grow promptly as national income rise, but may aslo degrade considerably if the economy fall into depression.

VI. CASE STUDY

The research of Vietnam Public Health University shows that each year, smoking kills 40,000 Vietnamese, four times the fatalities from traffic accidents [6] . Total expenditures of treating three common diseases involving smoking include lung cancer, chronic obsttructive pulmonary disease and ischemia heart disease comes to 1,100 billion VND/year [7] .

According to Mrs. Hoang Anh from Health Bridge Organization in Hanoi, at the same brand of cigarette, a pack of it in Vietnam has the cheapest price. The average retail price of cigarettes is 0.22 USD/pack – a price that almost cannot be found anywhere in the world [8] . Thus, the youth is easier to approach smoking since ciagarettes are too cheap and too simple to buy. In fact, as the statistics of SAVY (Survey Assessment of Vietnamese Youth) in 2003 – 2004, in the age of 14 – 25, 43.6 percent smoker is male and 1.2 percent is female, the rate of smokers increase with age. 71.7 percent male smoker continues smoking. Mrs. Hoang Anh said the reason of low-cost cigarette is because in Vietnam, the tax imposed on cigarettes is among the lowest. Recently, the WHO has recommended the cigarette tax should be at 65 percent / retail costs, however, Vietnam has just reached 46 percent [9] . The price elasticity concepts can be used in this case in an effort to deter people form smoking.

Tobacco products are kind of goods with inelastic demand since there is amost no substitute goods for them. Therefore, it is hard to reduce the amount of people smoking once they have been addicted. Moreover, cigarettes also have a high income elasticity of demand as people with high income will be willing to buy a lot more of packes of cigarettes, thus, they become more and more addicted.

One way to reduce youth smoking in particular and people smoking in general is to raise the price through higher cigarettes taxes. The reduction amount of youth smoking depends on the price elasticity of demand. This elasticity is elastic for teenagers than for adults. It is because teenager income is relatively low, the portion spent on cigarettes usually bigger than that of adult smokers. In addition, peer pressure affects a young person’s decision to smoke more than an adult’s decision to continue smoking. The impact of a higher price also reduces smoking by peers and thus, drives down the number of young smokers. Moreover, young smokers not yet addicted to nicotine are more sensitive to price rises than adults, who are likely to be heavy smokers. The experience from other countries encourages the efficiency of higher cigarette taxes in reducing people smoking. For example, Thailand government has regularly raised the cigarettes taxes nine times within 15 years (1992 – 2007) and recently, the amount of tax collected is 2-3 times more than Vietnam and the number of smokers is two-thirds less than Vietnam [10] .

Hence, Vietnam need to base on those determinants involving the price elasticies which bring about effects on demanding for cigarettes to apply in imposing appropriate taxes on that product in the earliest time. In fact, a WHO research indicates that if Vietnam raises about 20 percent the cigarettes taxes, then the retail costs will increase 10 percent. Thus, the government income will increase 1,500 – 2000 billion VND and avoid 100,000 fatalities by smoking anually [11] .

VII. CONCLUSION

Being able to grasp different types of elasticity concept is vital since it helps businesses to make the best decision in a wide range of activities. Return to the problem set up at the beginning, the answer can be seen to depends on the price elasticity of demand for the good. If the demand is elastic, the percentage change in quantity is bigger than the percentage change in price, so a sale increases total revenue. But if the demand for those shoes is inelastic, the percentage change in price is bigger than the percentage change in quantity, so a sale would decrease total revenue. Knowing that will be able the shop to consider if it is appropriate and wise to do a sale to gain the best benefit. Hence, elasticity measurements can help companies or businesses to understand whether what they are doing would bring positive results or not. This is significant, as in economics, resources are scarce, it is reckless to use them if the final objectives will not be achieved. In addtion, through the case study of detering people smoking above, it can be seen that the concepts of price elasticities are also useful in analyzing price conditions of a harmful good involving the demand for it so as to take the right actions to solve one of social problems.

VIII. REFERENCE LIST

1. Allan layton, Tim Robinson, Irvin B. Tucker, 2005, Economics for today, 2nd ed, Nelson Australia Pty Limited.

2. William A. McEachern, 2009, Economic Principles A Contemporary Introduction, 8th ed, South-Western.

3. John Jackson, Ron McIver, Chris Bajada, 2007, Economic Principles, 2nd ed, McGraw Hill Australia Pty Limited.

4. John Sloman, 2007, Essentials of Economics, 4th ed, Pearson Education Limited.

5. Thu Hien, Kien nghi tang thue thuoc la len 78%. Available at: http://kinhte24h.com/?a=TW&tw=VIEW&view=NEWS&category_id=73&new_id=55900.

6. Tuoi Tre, Se tiep tuc tang thue thuoc la den 2/3 gia ban le. Available at: http://hcm.24h.com.vn/thi-truong-tieu-dung/se-tiep-tuc-tang-thue-thuoc-la-den-2-3-gia-ban-le-c52a283227.html. Accessed on Wednesday, March 10, 2010.

7. Tuoi Tre, Tai sao gia thuoc la o Viet Nam lai re nhat the gioi?, available at: http://hcm.24h.com.vn/tin-tuc-su-kien/tai-sao-gia-thuoc-la-o-viet-nam-lai-re-nhat-the-gioi-c46a231980.html. Accessed on Sunday, May 31, 2009.