Why Is the Concept of Price Elasticity of Demand Important to Economics Analysis - Essay Example

Running head: MICRO- ECONOMY Research analysis Name Grade Course Tutor’s Name 25/ 11/ 2010 Demand analysis Demand is the quantity of a commodity that a consumer is willing and able to buy at given price over some given period of time. Therefore while giving the definition of demand three aspects must be mention. These are quantity, price and time period. Demand is different from desire in the sense that it has to be supported by ability to buy the product. Supply on the other hand is the quantity of a commodity that an individual producer/firm is willing and is able to offer for sale at a given price over some given period of time. Market supply refers to horizontal summations of individual producer or firms supplies in the market. Elasticity of demand Elasticity can be defined as the ratio of the relative changes of dependent variable to changes in the independent variable. Elasticity can be analyzed in term of demand and supply. Elasticity of demand can be defined as the measure of responsiveness of the quantity demand of a commodity to change in price, income, or price of other related goods (GRAPH 3 see the apendix). There are three type of elasticity of demand. Namely: price elasticity of demand, income elasticity of demand and cross elasticity of demand. Price elasticity of demand refers to the measure of responsiveness of the quantity of demand of a commodity to change in its own price. It is also refer to as own price elasticity of demand and it is abbreviated as PED. The price elasticity of demand is usually calculated as PED= proportionate change in quantity demanded divided by proportionate change in price. When change in price cause more than proportionate change in the quantity demanded, demand is said to be price elastic. In this case the value of elasticity of demand will be greater than 1. If the response in the quantity of demand to change in price is less than the proportionate, then the demand is said to be price inelastic. In this case the value of elasticity of demand is less than 1. The price elasticity of demand can be measured in two ways; point elasticity and arc elasticity of demand. Point elasticity of demand is the elasticity of demand at a particular point along the demand curve. It is normally calculated as change in the price divide by change in quantity, multiply quantity divided by the price. (GRAPH1)Arc elasticity of demand measures the elasticity of demand between the two points along the demand curve (GRAPH 2). Important of elasticity of demand analysis Determination of the sales revenues It is important for a business man to know the effect that change in the price will have on the quantity demanded for the products. If the demand for the product is price inelastic, then the business man might increase the revenues by increasing the price of the commodity. However, if the demand for the products is price elastic he will exercise caution while increasing the price for the commodity as this might lead to loss in the revenues. Elasticity of demand and the tax policy of the government The government levy taxes for various reasons such as raising revenues, discoursing consumption of certain goods and services, protect the local industries among others. The price elasticity of demand therefore affects the government total tax revenues as well as the pattern of consumer’s expenditure. If the objective of the government is to protect the local industries, the important commodity should be price elastic so that less of this commodities will be important when the custom duties are imposed similarly if the objective of the government is to raise the revenue the commodities targeted should be prize inelastic. Revaluation Devaluation refers to deliberate attempt by a country to lower the value of its currency when a country devalues its currency it make it cheaper relative to other currencies. The impacts of currency devolution are that export becomes cheaper while the imports become relatively more expensive. This aims at discouraging importation while at the same time it encourages exportation. For this policy to be successful both the export and the import have to price elastic. Economic growth Rapid economic growth will cause an expansion for the demand for luxury commodity which has high income elasticity. For this reason there will be more investments in the industries producing luxury commodities and less in those producing necessities. This in turn will change resource allocation with more resource being diverted to the production luxuries. Competitive industry If the firm is in a competitive industry, there will be a high positive gross elasticity of demand between its products and those products by the competing firms. For such a firm it not will be in its interest to the price of the product as this may result to more than proportionate fall in sales. However, it might consider lowering the in order to attract the customers from rival firm. For product with a high degree of complimentary fall to the price of one commodity say commodity A due to an increase in supply, this will benefit the product of other commodity B due to an increase in sales. For example if the price of a car falls due to an increase in supply, this will benefit supplier of the fuel to an increase in sales as more car will be demanded. Price elasticity There are five type of elasticity of demand namely; perfect elasticity of demand, elastic demand, unit elastic demand, inelastic demand and perfect inelastic demand. Perfect inelastic demand is said to be perfectly elastic when the consumer are willing to buy any amount of commodity at a given price but non at a slightly higher prices. In this case the price remains constant despite change in supply. In this case the demand curve is a horizontal straight line (GRAPH 4 see the apendix). This is the case of good in a perfectly competitive market where increase in price may lead to loss of all customers. Elastic demand is said to be price elastic if changes in price cause more proportionate changes in quantity demanded. For example if the price increase the quantity demanded fall the quantity demanded increases in greater proportions. In this case elasticity of demand is greater than 1 and demand curve will be gently slope (GRAPH 5). This is the case of luxury commodity which consumer can do without. It also applies to commodity which has a close substitute which is cheaper. Unit elasticity of demand is said to be unit elastic if the change in price causes a proportionate change in the quantity demanded. For example if the price fall the quantity demanded increase in the same proportionate and if the prices increases the quantity demanded falls in the same proportion(GRAPH 6). In this case elasticity of demand is equal to 1 or unity and the demand curve will be a rectangular hyperbola. This is the case of the commodity which lies between a necessity and the luxury. Inelastic demand is said to be inelastic if changes in the price cause less than the proportionate changes in the quantity demanded. If the price increases the quantity demanded falls in the lesser proportions (GRAPH 7). In this case elasticity will be less than 1 and the demand curve will be sleepy slope. This is the case of a commodity which is necessity; a commodity which cannot do without it but needs not to be consumed in a fixed amount like an absolute necessity. This also happen in case of habit forming commodity such as cigarette and beer. Perfect inelastic demand is said to be perfectly inelastic if changes in price has no effect on the quantity demanded. The change in the quantity demand is equal to zero. In this case elasticity of demand is equal to zero and the demand curve will be vertical straight line (GRAPH 8). This is the case of the commodity in a absolute necessity. The commodity that the consumer cannot do without it and must consumed in the fixed amount. E.g. salt. Other elasticity of demand Income elasticity of demand Income elasticity of demand can be defined as the measure of responsiveness of the quantity of demanded of a commodity to change in the consumer income. It is calculated as income elasticity of demand is equal to proportionate in the quantity demanded divide by proportionate change in income. If income elasticity of demand is less than 1 then demand is said to be an income inelastic showing that change in income bring about less than proportionate changes in the quantity demanded. If elasticity of demand is greater than 1 then demand is said to be income elastic showing that changes in income changes in income brings about more than proportionate changes in the quantity demanded. Cross elasticity of demand It can be define as the measure of responsiveness of the quantity demanded of a commodity to a change in to a change in the price of another good. It calculated as cross elasticity of demand equal to proportionate change in the quantity demanded of say commodity x divided by proportionate change in the price of say commodity y. the sign of cross elasticity of demand is positive if good x and y are substitute and negative if good x and y is complimentary goods. The main determinant of the cross elasticity of demand is the nature of the commodities relative to their uses .for example if the commodities can satisfy equally well the same need cross elasticity will be high and vice versa. References: Bowen, H.P.; A. Hollander and J-M. Viane (1998). Applied International Trade Analysis. London: Macmillan Press Krugman, P.R.; M. Obstfeld (1988). International Economics: Theory and Policy. Glenview: Scott, Foresman. APPEDIX  GRAPH 4,8, 6 RESPECTIVELY GRAPH 3,7 GRAPH 5            % Change in Price  GRAP 3 GRAPH 2, 1 6 Read More