Price Elasticity Of Demand Tutor2u

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The purpose of this essay is to define elasticity of demand, cross-price elasticity, income elasticity, and explain the elastic coefficients for each. I will explain the contrast of and significance of difference between the three. I will also explain whether demand would tend to be more or less elastic for availability of substitutes, share of consumer income devoted to a good, and consumer’s time horizon, and give examples of each.

Then, I will explain the logical impacts to business decision making that result from each.

Last, I will differentiate between perfectly inelastic demand and perfectly inelastic demand, and illustrate the difference between the terms. Elasticity of demand, also known as price demand elasticity, is defined as the measurement of “the responsiveness of demand for a product following a change in its own price” (tutor2u.

net). Sales may increase when a price goes down. Sales may also decrease when prices go up. Examples of products with elasticity of demand are appliances and cars.

When prices go down on cars, more people will buy them. The same can be said for appliances. For necessities such as food and clothes, you will see no significant change in sales with changes in price. This is called inelasticity of demand (business dictionary. com). According to Mike Moffatt, former About. com Guide, the cross-price elasticity of demand measures the rate of response of quantity demanded of a good, due to the price change of another good”.

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Consumers may purchase more of one good when the price of its substitute increases.

Positive Elasticity Of Demand

If the two goods are complements, meaning, you can’t have one without the other, a rise in the price of one good should cause the demand for both goods to fall. The formula for cross-price demand of elasticity is: (% Change in Quantity Demand for Good )/(% Change in Price for Good ) (economics. about. com). The measurement of how much the demand for goods change, with respect to a change in income, depends on whether the goods are luxuries or necessities. This measurement is known as income elasticity.

With the increase of income, the demand for necessities may increase, also, but at a slower rate. Sometimes the increase in income can go toward luxuries. The demand for luxuries tends to increase at a higher rate in response to the increase of income (investopedia. com). Inferior goods have negative income elasticity because if a consumer can go without them, they will stop buying them. According to The Penguin Dictionary of Economics, “a good that is not inferior is a normal good” (inferior good (2003)). A normal good can become inferior over a period of time.

An example of this is when a small apartment that you no longer have the need for because of a growing family. Normal goods have a positive elasticity because the demands for normal goods rise with income. The coefficient of income elasticity measures the percentage in change between two variables. The two variables are demand and income (IED= % change in quantity demanded/ % change in income) (Amosweb. com). Normal necessities and normal luxuries have positive coefficients because income and demand move in the same direction.

Although the coefficient for inferior goods is usually negative, they can turn into a positive over a period of time. For example, in a recession, the need for an inferior good may become a necessity, thus increasing the demand for that good (tutor2u. net). The coefficient for cross-price elasticity is the percentage of change in demand of a product (a) /change in price of a product (b) (Wikipedia. org). This formula sometimes yields a negative value due to the relationship between price and quantity demanded. It also depends on if the goods are substitutes or complements.

For a substitute, the increase in price for one good (a) will lead to the increase in demand for the other good (b), which makes the value of goods positive (economicsconcepts. com). This depends on if variable (a) is a necessity. In this case, the demand for that good may not change because of a change in price. According to J. Welkers, cross elasticity for complementary goods are negative because an increase in price of a product decreases the demand for that product (welkerswikinomics). The coefficient for elasticity of demand measures the relationship between two variables.

A formula for figuring out the coefficient of elasticity of demand is: (percentage change in quantity) / (percentage change in price). The coefficient will be the percentage change in quantity demanded in response to a one percent change in price, and will determine is if the demand for a good is elastic (eod>1) or inelastic (eod<1). Knowing the coefficient for the demand of a product gives a business the edge because they will know when to make adjustments to price in order to increase the demand for a product. Cross-price elasticity, Income elasticity, and Elasticity of demand all have different coefficient ormulas. The difference between cross-price elasticity and income elasticity is that cross-price elasticity measure the percentage of change in demand of a product in relation to change in price, while income elasticity measures changes in demand in relation to changes in income. The difference between these two and elasticity of demand is that elasticity of demand measures the responsiveness of demand to a change in price. Elasticity of demand determines whether a company can increase or reduce their price on a product, and is therefore detrimental to a company that is trying to maximize their profits.

Cross-price elasticity is similar, because it allows a company to market a product based on an estimate of the profit they believe they will make if they promote the sale of a good that’s already in demand by offering the complement at a discount to the consumer with a purchase. Once the consumer becomes a habitual buyer of the product, they are less sensitive to price changes. Knowing the income elasticity of demand for a good allows a business or firm to determine if a good is elastic or inelastic, meaning it may or not be sensitive to change in income (economics. about. om). These are the three determinants of elasticity demand: Availability of substitutes, share of consumer income devoted to a good, and consumer’s time horizon. “ A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied” (investopedia. com). The availability of substitutes is very important because, the more substitutes you have the more elastic the demand will be. An example of elasticity of demand in relation to availability of substitutes is having two brands of the same shirt.

If the price increases for the name brand shirt, consumers may begin buying the off brand shirt, instead. This leads to elasticity of demand. In order to make a profit, a business would have to increase the price for the good (investopedia. com). The logical impacts to business decision making that result from the availability of substitutes is a business will have to decrease their prices in order to stay competitive in the market. This is as a result of a decrease in demand. In order to reach equilibrium, prices will have to decrease before demand will rise (mindtools. com).

The share of a consumer’s income they are willing to devote to a good or service will determine the elasticity of demand for a good. Elasticity of demand will vary, depending on the consumers’ perception of the value of a good. When a price increase on a product has a larger share of the consumer’s income, demand for the product may become more elastic because the consumer may buy less of the product. An example is when the price of paper towels goes up $1 a roll, and you have to reduce the amount you usually buy. But when a price increase only takes a small share of a consumer’s income, the opposite is correct.

A consumer will buy more of a product, especially when it’s a brand name that they are true to. It really depends on how much of a jump in price it is, as well. Sometimes, they will just continue to buy the same amount of a good when there is a small increase in price. This makes the demand for a product less elastic because price has no or a relatively small effect on the quantity. A price increase on a good can make it seem more attractive. For example, when the price of gas goes up, consumers will adjust to the price change out of necessity. Price increase will hardly affect the demand for gas.

The impact a consumer’s income devoted to a good has on a business’s decision making is when considering a price change, a business will need to know the effect the change in price will have on total revenue (en. wikipedia. org). They will need to estimate how sensitive the consumer will be to a price increases for a good, whether it is a necessity, luxury, normal or inferior good. The effect that a consumer’s time horizon has on elasticity of demand depends on the price elasticity in terms of necessity. If the product is a necessity to a consumer and there is no substitute, the consumer will continue buying that product (tutor2u. net).

This makes the product inelastic or less elastic. If the consumer can find a substitute in the long run, and the price remains the same, the product will eventually become more elastic. An example of this is when a consumer faithfully purchases a case of cigarettes every week, but the price has increased by $5 because of a rise in taxes. The consumer’s income cannot support the increase in price. He can either cut back on consumption of this product or look for its substitute if there is any. If the consumer cuts back or stops buying the product as a result of a price increase, the decrease in demand will cause it to become more elastic.

The logical impact that consumer time horizon has on a business’ decision making is that it determines the elasticity of demand for a product. If the price increases by even a small percentage, over time the demand will decrease. If there is no substitute for this product, it may still increase in elasticity, but at a slower rate. Perfectly elastic demand and Perfect inelastic demand effect price elasticity. When demand is perfectly elastic, any small decrease in price will increase the quantity supplied, infinitely.

This is represented in a horizontal supply curve of the graph below. In contrast, when demand is perfectly inelastic, for any change in price, there is no change in the quantity demanded. This is represented in a vertical supply curve below (pinkmoney. com). The relationship between elasticity of demand and total revenue can aid a firm in setting its price. In relation to inelastic range of a demand curve, a price decrease would decrease total revenue (elasticity of demand (1995)). By increasing prices and minimizing demand, total revenue can be increased.

For elastic range, if the price decreases, demand and total revenue will increase. Therefore, a company can maximize profit by decreasing their price if they have an elastic demand. The value of unitary elasticity is exactly 1, and defines a perfect response of quantity to price. If demand is unitary elastic range, change in price will cause the exact change in demand and revenue (amosweb. com). In a unit elastic supply curve, a 10% increase in price yields a 10% increase in quantity; a unit elastic demand curve will have a decrease in quantity of 10% with a price decrease of 10%.

Below is a graph referencing the relationship between total revenue and elasticity of demand. (Businessbookmall. com) References http://www. amosweb. com/cgi-bin/awb_nav. pl? s=wpd&c=dsp&k=income+elasticity+of+demand http://www. amosweb. com/cgi-bin/awb_nav. pl? s=wpd&c=dsp&k=demand+elasticity+and+total+expenditure http://www. businessdictionary. com/definition/elasticity-of-demand. html http://www. businessbookmall. com/economics_19_how_elasticity_of_demand_affects_total_revenue. htm http://economics. about. com/cs/micfrohelp/a/cross_price_d. htm http://en. wikipedia.