Economic Principles - Assignment Example

Name: xxxxxxxxxx Course: MAE 101 Institution: MIBT Title: ECONOMIC PRINCIPLES ASSIGNMENT Date: xxxxxxxxxxxxx MAE 101: ECONOMIC PRINCIPLES ASSIGNMENT 1. What do you understand by the following terms? Explain using formulae, diagrams and examples. What are the determinants of the measurement of each term? i. Own price elasticity of demand ii. Cross price elasticity of demand iii. Income elasticity of demand Own Price Elasticity of Demand Own price elasticity of demand is a measure of the responsiveness of the quantity demanded of a product or commodity to changes in price. It is measured as a percentage change in quantity demanded due to changes in price. The formula for computing the price elasticity of demand is; Or, according to the diagram above, it can be computed as: As shown in the diagram below, if the percentage change in the quantity demanded is greater than the percentage change in price, the commodity has elastic demand but if the percentage change in price is greater than the percentage change in quantity demanded, then the commodity has inelastic demand. Normally, if the price elasticity is lesser than one, the commodity is considered to be inelastic since a one percent increase in the price would lead to a reduction in demand by less than one percent. If for example the price of a commodity such as computers increases by 5% and as a result of this increase the demand for computers decreases by 2%, then the price elasticity of demand for computers is -0.4% which is relatively inelastic. This also shows that a one percentage decrease in the price of computers would only increase the demand for computers by 0.4 % which is demand inelastic. The price elasticity of demand for a commodity is determined by certain factors. The nature of the commodity determines its price elasticity. If the product is a necessity such as vegetable oil, milk or electricity, it would have an inelastic demand since changes in price would have little impact on demand since people cannot do without it. But for luxuries such as diamond rings, cigarettes, fur coats or expensive sports cars, demand is elastic since if you increase the price, consumers can do without it or will simply look for other substitutes. Similarly, if the product has no close substitutes, its demand will be inelastic since consumers cannot adapt accordingly to increases in price. The percentage of income spent on the commodity will also determine elasticity- the lower the percentage the more inelastic it is. Similarly, amount of time it takes for consumers to adjust to price changes also affects own price elasticity. In the short run, demand is inelastic but as consumers make adjustments based on income and habits, demand becomes more elastic. Cross Price Elasticity of Demand The cross price elasticity of demand is a measure of the percentage change in the quantity demanded of one product due to changes in price of a related product. The formula for cross price elasticity between product A and B is: As can be seen from the diagram below, if an increase in the price of Y leads to a decrease in demand for X, the two goods are close complements such as bread and butter, printers and ink cartridges, keyboards and computer monitors or fountain pens and ink which are frequently used together. However, if an increase in the price of B leads to an increase in demand for B, the two are substitutes such as movie tickets and DVDs, new cars and old cars or butter and margarine from which the consumer can chose either according to their discretion. Cross price elasticity is determined by the strength of the relationship between the two products. If the two products are close substitutes, the cross price elasticity will be strong and positive but if the two are complements, the cross price elasticity will be strong but negative. If the two commodities are unrelated, they will have a cross price elasticity of zero. Income Elasticity of Demand Income elasticity of demand is a measure of the percentage change in the quantity demanded of a particular product due to changes in the consumer’s income. It is usually calculated by the formula: The income elasticity of demand of a commodity depends on whether the commodity is classified as a normal good or an inferior good. Normal goods have positive income elasticity of demand- the quantities demanded of these goods increases with an increase in the customers’ income. These include luxury products such as chocolates, diamonds or items such as laptop computers or I phones. On the other hand, inferior goods are goods for which the quantity demanded decreases as the consumer’s income increases and thus have negative income elasticity of demand. These include low income bare necessities such as bread, potatoes and public bus tickets as the consumer prefers items such as cakes, pastries and taxi services which they can now afford due to the increase in real income. 2. Consider the following information, produced by a market research agency, about a model of car your firm produces-the Magpie- and a competitive model, the Eagle. All the information relates to long term market adjustments. Own price elasticity of demand for the Magpie -2.7 Cross price elasticity of demand with respect to the Eagle - 3.2 Income elasticity of demand for the Magpie target market + 1.5 Using the concept of cross price elasticity of demand, does your firm have market power in respect to the Eagle? Why or why not? The firm does have market power in respect to the Eagle. The cross price elasticity of demand for the Magpie with respect to the Eagle is -3.2 implying that a one percentage increase in the price of the Magpie will reduce the quantity demanded of the Eagle by 3.2 percent. Thus the firm can affect the demand for the Eagle by increasing or reducing the price of the Magpie. 3. Explain the relationship between the Magpie and the Eagle. The Magpie and the Eagle are complements owing to the sign and the magnitude of the cross price elasticity of demand of the Magpie with respect to the Eagle. Complements or complementary goods are commodities which are frequently used alongside each other such as bread and butter or computers and printers. Thus an increase in the demand for one commodity will lead to an increase in the demand for a complementary good. This also means increasing the price of one commodity will not only reduce the demand for it but also for the complementary good which implies a negative cross price elasticity of demand. The Magpie has a cross price elasticity of -3.2 with respect to the Eagle which shows that the two are complementary. 4. Explain what would be the effect of a 10% increase in the income of the target market have on the demand for the Magpie? The income elasticity of demand for the Magpie is + 1.5 which implies that a one percent increase in income will increase the quantity demanded of the Magpie by 1.5 percent in the target market. Thus a 10 percent increase in the income of the target market will increase the demand for the magpie by 15 % (10 x 1.5 = 15%). 5. Your firm’s accountant argues that because the demand for the Magpie is price elastic, the firm should drop its price. Briefly discuss this recommendation indicating if you would support this recommendation or not. Give reasons for your advice to management. The own price elasticity of demand for the Magpie is -2.7. This means a one percent increase in the price of the Magpie would reduce the quantity demanded by 2.7 percent. The price of the Magpie is thus highly elastic since the magnitude of the reduction in price is greater than that of the increase in price. Thus by increasing the price of the Magpie, the firm stands to lose revenue and subsequently profit due to a significant reduction in demand. If the own price elasticity of demand were less than one-inelastic, the firm would offset the reduction in demand through the additional revenue generated by increased prices. Thus according to the accountants’ recommendation, reducing the price of the Magpie by one percent would increase the quantity demanded by 2.7 percent. As a result, the firm would offset the reduction in price through the increased revenues expected from the increase in sales due to increase in quantities demanded of the Magpie. I would thus support the accountant’s recommendation since it would increase the firm’s revenues and subsequently profit by increasing demand in proportion to the reduction in price. Bibliography Estrin, S. & Laidler, D.W., 1995, Introduction to Microeconomics, 4th Edition, Harvester Wheatsheaf, University of California. Read More