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Definition and determinants of price elasticity

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Published: Mon, 5 Dec 2016

Definition of price elasticity (PES) to supply refers to a measurement of relationship between change in quantity supplied and a change in price. There is a few determinants that affects the outcome of the PES.

One of the determinants is time period. Supply will be more elastic when time given to a company to change its adjustment is more. In short run, the time given to firms and companies are too short to adjust or change and adapt. For example, Sammy’s burger face a shortage of beef meat as raw material. It is inelastic if the time period is limited to a few hours only. The price of the burger might increase but the there is simple no other methods to help Sammy. In long run, time given to firms and producers are long enough to adjust their firm size and prepare for firms to enter or leave. In this way, Sammy would have enough time to search for alternate way for new resources.

Another determinant is resource substitution possibilities, which means some goods or product that can only be produced or made by using special technique or limited resources. These products have a very low elasticity of supply or maybe zero. However goods which are commonly produced that could be simply found have a relatively high elasticity of supply. Example, Louis Vuitton handbags are all handmade from genuine leather, hence there are less products that may substitute it. The PES of Louis Vuitton is much more inelastic.

Question 2B

Price

Businesses can use the concept price elasticity to decide their pricing strategy by determining whether the good to be sold is inelastic, elastic, unitary, perfectly inelastic, and perfectly elastic. If the price elasticity is inelastic it shows that the percentage change in quantity demanded is less than the percentage change in price. For example, good A is given a discount of 10%, but quantity demanded only increased slightly by a 3%, thus is will be a smarter way to gain more profit by increasing the price instead of decreasing and only quantity demanded will only decrease slightly. Diagram 2.1 shows the demand curve of this case.

10%

Quantity demanded

D

Diagram 2.1- Inelastic Demand

4%

Furthermore, when the demand of a certain good is elastic it shows a scenario which the percentage change in quantity demanded is larger than the percentage change in price. For example, good B is an inelastic good, hence giving discounts or decreasing the price will attract more customers, thus increasing the total revenue of the business. Diagram 2.2 shows the demand curve of good B decreasing the price by 10% and earning 20% more quantity demanded.

Price

10%

D

20%

Quantity demanded

Diagram 2.2- Elastic Demand

Thirdly, if demand of a good is unitary elastic, which the percentage change in quantity demanded equals to the percentage change in price. Any rise in price will be exactly offset by a fall in quantity, leaving the total revenue unchanged. In Diagram 2.3, it shows that when given a 10% discount, quantity demanded will increase by 10%; the total revenue earned is the same as before discount. Therefore, producer should decrease the price of product, manufacturing less goods saving more time and man power and redirecting it to another productive product.

Price

10%

D

Quantity demanded

Diagram 2.3-Unitary Elastic

10%

When demand is perfectly inelastic, the quantity demanded will not change as the price change. Consumers will not response to any change in price at all. In diagram 2.4, it shows that when price decrease by 10%; no changes are to be seen. Hence if producers increase the price of the product, quantity demanded will not be affected.

Price

D

10%

Quantity demanded

Diagram 2.4- Perfectly Inelastic

Price Last but not least is perfectly elastic demand, where only slight percentage change in price will cause an infinite percentage change in quantity demanded. This means that consumers have a great response to a change in price. Hence, producers should remain the price or follow the market value and not simply changing the price because a small change can bring an infinite change in quantity demanded.

D

Quantity demanded

Diagram 2.5- Perfectly elastic

Question 3A

Supply is the production of a certain good or product by suppliers or future suppliers for the market a variation of price at a certain time period. From the law of supply, if the price of a certain good increase, so will the quantity supplied of the good. A supply curve is a graph that shows quantity of goods that producers will supply according to the price. The graph will always sloped upwards to the right side because quantity supply is bigger at a dearer price. Diagram 3.1 shows how a supply curve is.

Price

Quantity supplied

Diagram 3.1

S0

Price

There are a few reasons supply of a product will increase. If there is an increase in supply, the supply curve will shift rightwards. Diagram 3.2 shows a shift in the supply curve from S0 to S1.

S1

Diagram 3.2

Quantity supplied

Firstly, a decrease or increase in the cost of making a good will determine the supply. In this case, cost of raw material or packaging too will affect the cost price. If cost of raw material for a certain good drop, suppliers will tend to produce more good and hence the supply will increase. Example, the cost of flour drops and results to an increase supply of bread. The drop in cost of flour the raw material of bread will lower down the cost of production thus suppliers will be able to produce more. Hence, the supply increases.

Secondly, the improvement in technology will affect the supply of a certain good. Improvement in technology is able to decrease the cost of production and increase productivity of a certain good, thus resulting in an increase in supply of good at every price level. For example, the development in robotic arms and computers enabled car manufacturers to produce cars in a faster pace yet with a promising product. Hence, car manufacturers can cut cost at man power and also costly mistakes. Supply will increase as the technology continues to develop.

Last but not least, is the price of substitute goods and competitive goods that may affect the supply of a good. Producing these goods requires similarly the same raw material. Hence, producers will choose to concentrate on the product which is more profitable and a better demand rate. Example, nukia N99 is more popular compared to nukia M99, thus producers will try to produce more nukia N99 which is more profitable than nukia M99. Hence supply of nukia N99 will increase.

Question 3B

Economists are saying that price floor and price ceilings can control the distribution of scarce good to those consumers who value them most highly. Price floor also know as minimum price is set above the equilibrium price to take effect. By doing so, goods have to be sold at a minimum price; hence minimum profits are earned by suppliers. On the other hand, price ceiling or the maximum price is set below the equilibrium price to take effect, lowering the price will attract consumers. Diagram 3.3 shows the price floor and Diagram 3.4 shows the price ceiling.

Price

S

e

Pe

D

Piece ceiling (Max. price)

Diagram 3.3 – Price Ceiling

Quantity Demand

Price

D

S

Quantity Demand

Piece Floor (Min. price)

e

Pe

Diagram 3.4- Price Floor

S : Supply curve

D : Demand curve

Pe : Price Equilibrium

e : Equilibrium point

Rationing function of price is the increase or decrease in price to clear the market of any shortage or surplus, while the resource allocation defines as an amount of resource given to a party for a specific purpose. The price floor and price ceiling are said to be stifle the rationing function of prices and distort resource allocation because they are made by the government to make sure suppliers gain profit. But this may result in surplus between demand and supply. As an example, good A is set at a price floor of $20 which is $5 more than the price at equilibrium. Some consumers are willing and able to buy the product at a higher price, and producers will continue supply good A. producers may raise the price of good A, but in return less consumer will buy it. This may result a surplus in the market. Other than that it also results distort resource allocation because not all products are able to be sell out.

S: Supply curve

D: Demand curve

Pe: Price Equilibrium

S

Price of good A

surplus

$20

Pe

D

Quantity demand of good A

Furthermore, once a price ceiling is put onto a good by the government, a shortage will happen between the supply and the demand of the product which eventually causes stifle of rationing function of prices and distorts the resource allocation. For example, salts have a price ceiling of $3 per packet, which is determined by the government. In other words, consumers are able to buy salt at a much cheaper price. But suppliers will not be able to make a better profit; hence supply will be limited by producers. This results to a shortage of salt in the market. Distort resource allocation occurs, thus not all consumers are able to buy salt because of the stocks are limited.

Price of salt (per packet)

S: Supply curve

D: Demand curve

Pe: Price Equilibrium

Quantity of sugar (package)

S

Shortage

Pe

$3

D

Question 5A

The definition of demand can be defined as quantities of a good or service that people are ready and willing to buy at various prices within some given time period, other factor besides price held constant, ceteris paribus.

Price of Cintan

First of all, a change in demand will cause the demand curve to shift rightwards. Other than the price of the good itself, there are a few other determinants that leads to a shift in the curve. Some of the determinants are price of substitute or complementary good, size of a household income, taste and fashion, weather condition, and etc. the curve will shift rightwards if there is an increase in demand and vice versa. Example, a drop in the price of Maggie instant noodle which is the substitute of Cintan instant noodle drops from $3 to $2. In this case, the demand of Cintan will drop, hence the demand curve of Cintan will shift leftwards. This is because consumers will be attracted by the cheaper good and not the dearer one. According to the law of demand, as the price of a good decrease, the quantity demanded of the good rises and vice versa, ceteris paribus. Diagram 5.1 shows the demand curve of Cintan instant noodle shift from D0 to D1 when a there is a decrease in demand.

D1

D0

Diagram 5.1

Quantity Demanded

On the other hand, a change in quantity demanded is shown as a movement along the demand curve. The one and only factor which can results a change in quantity demanded is the price of the good itself. When the price decreases, the quantity demanded will increase and vice versa, ceteris paribus. For example, in Diagram 5.2 an upward movement from A to B along the demand curve due to an increase in price of cheese from $5 to $8. The quantity demanded of cheese decreases from Qd0 to QD1 according to law of demand.

Price of cheese($)

8

B

5

A

Diagram 5.2

D

Qd1

Qd0

Quantity demanded of cheese

D: Demand curve

A: point A

B: point B

Qd: Quantity demanded

Question 5B

Income elasticity of demand (YED) shows the proportionate change in the demand for a good in response to a change in household’s income. YED can also be explained as the percentage change in quantity demanded divided by the percentage change in household’s income. Below is the way YED is written down in formula form:

The percentage change in quantity demanded

YED =

The percentage change in household’s income

There are several degrees affecting the YED. First degree of all is the positive YED. The outcome of the YED is a positive outcome, which means that demand will rise as income rise too. Positive YED can be further broken down into two categories, income elastic and income inelastic.

Income elastic is said to be income elastic when the outcome is greater than 0 but lesser than 1 (0< YED <1). This is because the percentage change in quantity demanded differs slightly more than the percentage change in household’s income. The good is known as a normal good, example of normal good is shirt, food and travel.

On the other hand, when the value of YED is greater than one (YED> 1) it is said to be income inelastic. This is because the percentage change in quantity demanded differs by a large percentage over the percentage change in household’s income. The good is known as luxury, example of luxury goods are branded items, sport cars, and branded clothes.

Second degree of YED is negative YED, which is a negative outcome of YED value (YED< 0). In this case, when demand falls, income rises. Goods under this degree are known as inferior good. Example of inferior goods are second-hand items, replica items, and low class good.

Last but not least is when YED equals exactly to zero (YED = 0 ). This only occurs when the quantity demanded does not change as the income changes. All the goods under this degree are necessity. Basic needs such as rice and salt are utilized on daily life, hence income will not affect the demand.

Question 6A

Diagram 6.1 Consumer surplus is the difference between total amount that consumers are willing and able to pay for a good or service and the total amount that they actually pay. Producer surplus is the difference between what producers are willing and able to supply a god for and the price they actually receive. The level of producer surplus is shown by the area above the curve and below the market price.

Price of good

Consumer Surplus

S: Supply curve

D: Demand curve

Pe: Price equilibrium

Q: Quantity

D

S

Pe

Quantity of good

Producer Surplus

Consumer surplus shows the highest price customers are willing to pay and the market price that they are actually paying for. Consumer surplus tells us that customers gets the benefit from paying lesser than the actual price. The area under the demand curve and above the price equilibrium represents the consumer’s surplus. For example. A consumer whom is willing to pay $20 for Good A but the actual price for Good A is only $5 to have it. Hence the consumer surplus is $5 which is the value that is paid lesser than what he is willing to pay. Other than that, the area above the supply curve and under the price equilibrium represents the producer’s surplus. For example, producers are willing to sell their product shoe at a price of $100 but instead the market paid them $200. Hence, the producers received $100 more than they are willing to take, $100 is the producer’s surplus.

(Geoff Riley, Eton College, September 2006, http://tutor2u.net/economics/revision-notes/a2-micro-consumer-producer-surplus.html .)

Question 6B

Scarcity, choice and opportunity cost are the three basic concepts of economics. Scarcity is a case where human needs are in excess compared to resources available. Choice is the time where humans are force to make a choice by scarcity between two or more choices. But for every choice humans make, another will be sacrificed, and the sacrificed choice are known as opportunity costs.

The above concepts are best explained by a production possibility frontier graph (PPH) that shows various maximum combination of two outputs that the economy produce. A few assumptions are set on the PPF graph- only two products produced, efficient production, fixes production, and fixed technology. Moreover, any points outside the reach of the PPF is unattainable points and the point which lies beneath the PPF is possible to achieve and is also known as attainable points but usually not desirable, inefficient points. While points on the curve are possible outputs that is known as efficient points.

E

B

A

10

9

C

8

5

D

2

4

3

1

0

Diagram 6.1

Combinations

Television

Radios

A

0

10

B

1

9

C

2

8

D

3

5

E

4

0

Table 6.1

In this case, the society faces a scarce resource to produce televisions and radios. Therefore, the society will have to make a choice to produce which good more or less. If combination A is chosen, 10 radios will be produced while none for television. 4 television are sacrificed or taken as opportunity cost. The following combinations happens as the table shown above.


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