ELASTICITY OF DEMAND 7
A.Discuss elasticity of demand as it pertains to elastic, unit, andinelastic demand
Elasticityof demand is obtained through comparing the percentage change ofquantity demanded with the percentage change in prices of products.Demand has various forms such as elastic, inelastic or unitary.Demand is elastic if a change in the price levels will result in alarger change in quantity demanded. The formula mostly used is asfollows:
Exy= Percentagechange in the quantity demanded of good X
Percentagechange in the price of good Y
Forexample, if the price of a product dropped by 10% and the quantity ofproducts demanded increased by 40% the ration resulting from thiswill be 40/10 = 4. This means consumption will increase, as consumerswill buy more of these products. If the prices of products that areconsumed infrequently (i.e. luxurious) increases the consumer maydecide to postpone buying those goods. If there are close substitutesfor the product, elasticity of demand will be affected becauseconsumers can easily switch to the substitute when prices of theproduct increase. This is evidenced by the increased consumption ofpoultry in the recent years due to the reduced prices of poultrywhile consumption of other meat products such as pork and beef havereduced due to their high prices.
Onthe other hand, demand is inelastic if a change in price results intoa small change in quantity demanded. Examples demonstrating inelasticdemand are food and petroleum. If the prices of these goods increaseconsumers will not stop consuming them. The demand curve in this casewill look steep because the demanded quantity does not change as muchas the price changes.
Finally,there is unit elastic demand where the coefficient is equal to one. Achange in quantity demand divided by a change in price should beequal to one. For example, a 20% increase in prices leads to a 20%increase in goods demanded. We therefore conclude that a one percentchange in quantity of goods demanded is as a result of every onepercent change in price.
B.Discuss cross price elasticity as it pertains to substitute goods andcomplementary goods
Crossprice elasticity measures the relative responsiveness of demand forone good due to the relative price change of another good. Thepercentage change in demand of one good is compared with thepercentage change in price of the second good. For example, thedemand of new cars that are inefficient will decrease by 20% if theprice of fuel increases by 10%. A cross elasticity that is negativerepresents products that are compliments while a positive onerepresents two substitute products (Hall & Lieberman, 2012).
With the existence of perfect substitutes, then cross elasticity ofdemand will be equal to positive infinity, that is, at a point whereboth goods can be used interchangeably. For example, if the price ofPepsi increases, the demand for Coca Cola would increase becausethese two goods are substitutes. Compliments are goods with negativecross price elasticity. Fuel and cars are examples of complimentsbecause cars cannot work without fuel. The two goods are unrelated ifthe cross price elasticity of demand is zero (Hall & Lieberman,2012).
C.Discuss income elasticity as it pertains to inferior goods and tonormal goods (sometimes also called superior goods)
Incomeelasticity of demand measures the responsiveness of goods demandeddue to change in income of consumers. For example, a 30 % increase inincome will increase the demand for goods by 40%. Income elasticityof demand in this case is calculated as the ratio of the percentagechange in demand to percentage change in income, that is, 40%/30% =1.33. The formula mostly used is as follows:
Percentagechange in quantity demanded
Percentagechange in income
Inferiorgoods have a negative elasticity of demand. This is because if thereis an increase in income demand for inferior goods will fall. Fornormal goods, demand will increase if income of consumers increases.A necessity good is one that has income elasticity of demand that isless than one, and a luxury or superior good is the one withelasticity of demand of more than one. Income elasticity of demandthat is zero when income of consumers increase has no effect or isnot correlated with a change in demand of a good. These are known assticky goods.
Incomeelasticity of demand can be used to determine the health of anindustry and the future consumption that is then used to make futureinvestment decisions. This can be determined by calculating theincreasing portion of consumer budget that will be devoted to buyingrestaurant meals and automobiles and give a small portion to tobaccoand margarine (Tomek, 2014).
D.Use an example to discuss why demand tends to be relatively elasticin a situation where “Availability of Substitutes” exists
Availabilityof substitutes means that consumers of the products that prices haveincreased can easily switch to the substitute products. Goods thathave greater availability of the substitutes are more sensitive tochanges in prices. If more substitutes are available, consumersbecome more powerful and can respond to price changes more easily.For example, Auntie Noodles Frozen Macaroni is one of the thousandsavailable nutritious food products existing in the market and becausethere are a lot of substitutes the price elasticity of demand isextremely elastic.
E.Discuss the “Proportion of Income Devoted to a Good” concept bycontrasting two products purchased
Whenother things are kept constant, the proportion of income spent on agood, the greater the price elasticity of demand for the good. Forexample, if the price of relatively low-priced pencils increases by30% and because this amount is a small proportion of people’sincome the quantity demanded will reduce by 5%, which is a smallchange. But, if for houses or automobiles it is different becausethey are relatively high-priced and an increase in price by 30% meansthat people will have to spend more to acquire them. The priceincrease is a significant fraction of the annual incomes ofindividuals and the demand for the goods will reduce by 20%, which isa very high proportion. Due to increase in prices for houses andautomobiles, people will look for other alternatives such as livingwith friend or sharing the cost of buying a car with their friendsthus reducing demand for those goods. Price elasticity for thesegoods tends to be high.
F.Contrast how a person would initially respond to a relatively largeincrease in the price of a product in the short run as opposed to howthat same person might react to that same price increase over alonger time horizon (i.e., the long run), using the “using the“Consumer`s Time Horizon” concept
Elasticityincreases over time. For example, if the prices of petroleumincrease, the behavior of people on how to use their cars will notchange because they need to go to work. This shows that the needs ofconsumers do not change in the short run. But in the long runconsumers will find other means to reduce their expenses by sharingcars, taking a bus or buying a more economical car. Demand for fuelis price elastic and also is income elastic. This means thatconsumption of oil will continue despite increase in the prices ofoil because oil is a must thing since our daily lives are dependenton oil. As income of people increases, people will consume more fuelbecause they will travel more. This proves that fuel is priceelastic.
G.Identify by price range the areas on the demand curve where demand iselastic, inelastic, and unit elastic using the attached “Graphs for, Total Revenue.”
1.Explain the corresponding impact on total revenue for each of thethree price ranges identified in part G.
Elasticityis shown to decrease as prices reduce and the quantity demandedincreases. At $50-$40, demand is unit elastic because 4-5 units areproduced where the revenue is at its maximum. At price above $50 thatis, $60-$80 demand is seen to be elastic thus increasing the totalrevenue. While below $50, that is, $40-$10 demand is inelasticbecause there is decline in revenue. As prices increase demandreduces hence the total revenue will reduce.
Byproducing 4-5 units demand is unit elastic and the firm will receiverevenue that will be at its maximum but after the fifth unit, thatis, 6-9 the revenue generated will start declining. By producing 1-3units, the revenues of the firm are seen to increase at an increasingrate. The maximum total revenue of the firm can be achieved byproducing 4-5 units.
Hall,R., & Lieberman, M. (2012). Microeconomics:principles and applications.Mason, OH: Cengage Learning.
Sherman,J.H., Hunt, E.K., Nesiba, R., O`Hara, P., and Weins-Tours, B. (2008).Economics:an introduction to traditional and progressive views (7thed). New York: M. E. Sharpe.
Tomek,W. G. (2014). Agriculturalproduct prices.New York: Cornell University Press.