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Consumers in a market economy are inclined by various factors in deciding what to buy. One of these factors is price, and the law of demand that defines the typical relationship between price and quantity demanded. It states that consumers will demand particular product at a lower price, and less at a higher price. However, the price elasticity of demand extends this and observes the extent of such changes in demand in relation to price. It is the sales director's duty to check the demand increase or decrease in response to a price change in business. So using the methods in elasticity of demand we can analyze the profit of the firm and also revenue.
The making of economic goods is the task and responsibility of entrepreneur. Economic goods produced must be those that will satisfy human needs. The same rule of maximum utility per hour can be applied to many different areas of life, including engaging in charitable activities, improving the environment or losing weight. It is not only a law of economics. It is a law of rational choices. No one can understand the behavior of consumers at all time with exactness. No one could predict exactly the demand would be, when the price of goods changes. The principles of consumer demand suggest that we will make the best use of our money when we equalize the marginal utilities of the last centavo spent on each good with any other good to achieve maximum satisfaction or utility. In analyzing consumers demand the entrepreneur will think in another way that the consumer will still buy the goods when price increases? The demand of consumers will then become elastic. Elasticity refers to the reaction or response of the consumers to change in prices of goods and services.
Elasticity of demand also may depend on the relative change in quantity and price. Buyers may tend to reduce their purchases as price increases, and tend to increase their purchases when price decreases. The change in price is not the only factor that may change the reaction of consumers. The nature of the product (similarity to what he uses) and the particular needs of the consumer (whether important or not) may also affect the change in the reaction or response of consumer. Here I have done the analysis of "Prime" supermarket using the price elasticity of demand to improve the profit and revenue of the supermarket.
"Prime" operates a total of 16 supermarket outlets in SingaporeÂ´s public housing estates to serve all the consumers better. It has its own department for purchasing and distribution centre located at "Prime" building at 125 Defu Lane 10 to ensure quality supply of goods. Tan Chye Huat holdings are Prime holding company. Some of the "Prime" Supermarket in Singapore is located at 25A Chai Chee Road, 263 Compassvale Street, 108 Punggol Field, Blk 678 Woodlands Avenue 6. Prime Singapore was among the earliest to push into the supermarket business, started with mini-mart operations from 1984 to 1988, before going on to medium sized ones. Full fledged "Prime" Supermarkets occupying 10,000 sq. ft. (929 sq. m.) and above came into existence in 1991, to its full strength to a striking supermarket chain with 16 outlets.
Although the supermarket business being no longer a growth industry it remains without a doubt an essential form of business to consumers as well as the retailing administration. In spite of the competitive nature of this industry, "Prime" Singapore runs two supportive trading arms to boost its position, one import and supplies fresh goods such as vegetables and seafood, while the other focuses on consumer lifestyle goods from Southeast Asia and China. In 2005, "Prime" started taking steps to be more adjusted to shifts and changes in consumer lifestyles and expectations. When Prime Singapore extended its supermarket operations to 24 hours, it elevated and redefined the concept of suitable supermarket shopping. "Prime" was among the first to provide this level of service to consumers.
In 2007 when "Prime" Singapore started to give more than a handful of its outlets a revamp of varying magnitude in a bid to provide a more comfortable ad friendly shopping environment. Prime Singapore also embarked on a journey to equip its employees with better customer service skills under the Customer-Centric Initiative program. Hereafter, Prime Singapore will be actively improving the development and promotion of its house brand, Prime Choice, a total company training programmed for front line management staff and launching its next stage of upgrading and renovations.
2. Demand Theory
One of the most important aspects of managers/sales directors is the analysis of demand. The market demand function for a product is the relationship between the quantity demanded of the product and the various factors that influence this quantity. Generally the market demand function can be written as
Quantity demanded for the good X = f (price of X, incomes of consumers, tastes of consumers, prices of other goods, price of commodity.)
For the simplicity we can rewrite the demand function equation as
Q = f (I, T Py , Px)
Where Q = the quantity demanded of commodity X by an individual per time period
I = the consumer's income
T = the tastes of the consumer
Py = the price of other goods (substitute and complementary) commodities
Px = The unit price of commodity X
Elasticity of demand is important, because it can predict the total revenue received when a company changes the price of a product.
The theory of demand is mainly classified into three categories, they are
Price elasticity of demand.
Income elasticity of demand.
Cross price elasticity of demand.
2.1 The Price Elasticity of Demand
Price elasticity of demand [ED] is the responsiveness of demand for a product following a change in its own price. The price elasticity of demand measures the responsive of the quantity demanded of a good is to a change in its price. The value denotes, if the good is relatively elastic (if ED is greater than 1) or relatively inelastic (if ED is less than 1).
For some goods, a small change in its price results a big change in quantity demanded, similarly for other goods a big change in its price will result in a small change in its quantity demanded. So to indicate the sensitive quantity demanded to change in its price the managers use a measure called the price elasticity of demand. It can also be defined as the percentage change in quantity demanded resulting from a percent change in price.
ED = (%change in quantity) ï‚¸ (% change in price).
2.1.1 Understanding Values For Price Elasticity Of Demand
If ED = 0 then demand is said to be perfectly inelastic. This means that demand does not change at all when the price changes, then the demand curve will be vertical
If ED is between 0 & 1 (i.e. the percentage change in demand from A to B is smaller than the percentage change in price), then demand is inelastic. Producers know that the change in demand will be proportionately smaller than the percentage change in price
If ED = 1 (i.e. the percentage change in demand is the same as the percentage change in price), then demand is said to be unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending by the same at each price level.
If ED > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For example a 20% increase in the price of a good might lead to a 30% drop in demand. The price elasticity of demand for this price change is -1.5
A product's ED is measured by various factors, they are
Number of substitutes: Larger the number of close substitutes for the good, then it is easier for the customer to shift to the alternative good if the price increase. Normally, the larger the number of close substitutes, more elastic is the price elasticity of demand.
Degree of necessity: If the good is a necessity item, then the demand is unlikely to change for a given price change. This shows that necessity goods have inelastic price elasticity of demand whereas luxuries have more elastic demand because consumers can live without luxuries when their budgets are stretched,
Price of a good as a proportion of income: It was seen that goods that account for a large proportion of disposable income tend to be elastic. This shows that consumers are more aware of small changes in price of expensive goods when compared to small changes in the price of inexpensive goods.
The following example can determine the price elasticity of demand for a good.
The "Primes" own produced strawberry jam is likely to be elastic. This is due to a large number of close substitutes (both in jam and other preserves) and the good is also not a necessity item. So the consumers will easily respond to change in price.
ED = Relative change in quantity demanded / Relative change in price.
= [% ï„Q ï‚¸ % ï„P]
= [ ï„Q ï‚¸ Q ]
[ï„P ï‚¸ P]
= (ï„Qï‚¸ï„P) x (Pï‚¸ Q)
ED = ï„Q. (P2+ P1) ï‚¸2 = Q2 - Q1 *. P2 + P1
ï„P (Q2+ Q1) ï‚¸2 P2 - P1 * Q2 + Q1 â€¦â€¦â€¦â€¦â€¦.. (i)
We can consider an example to analyse about the price elasticity of demand in our super market .Table below shows the demand schedule of fresh juice.
Price (in $),[ P]
Total revenue, [TR]
From the above table we can find the price elasticity of demand of a product using the equation (i) as derived above.
So when price (P) goes from $4 to $5 and quantity (Q) goes from 7 to 6, then the price elasticity of demand becomes
PED = [(6-7) ï‚¸ (7+6)] ï‚¸ [(5-4) ï‚¸ (4+5)]
= (1ï‚¸6.5) ï‚¸ (1ï‚¸4.5)
= 0.1538 ï‚¸ 0.2222
= - 0.69
Similarly when P goes from $5 to $6 and Q goes from 6 to 5 then,
PED = [(5-6) ï‚¸(6+5)] ï‚¸ [(6-5)ï‚¸(5+6)]
= [1ï‚¸5.5] ï‚¸ [1ï‚¸5.5]
Similarly if P goes from $6 to $7 and Q goes from 5to 4 then,
PED = [(4-5) ï‚¸ (5+4)] ï‚¸ [(7-6) ï‚¸ (6+7)]
= (1ï‚¸4.5) ï‚¸ (1ï‚¸6.5)
= 6.5 ï‚¸ 4.5
Table below shows the elasticity of demand and the total revenue, considering the above example.
From the above example it is clear that, the price elasticity of demand should be less than one to get the increase in total revenue of the supermarket. So when price changes from $4 to $5 we get the maximum revenue that is when elasticity of demand (ED) <1.
2.2 Income Elasticity Of Demand
Income elasticity of demand defined as the relationship between changes in quantity demanded to a change in income. The basic formula for calculating the coefficient of income elasticity is percentage change in quantity demanded of good X divided by the percentage change in consumer's income. Super markets will be affected due to income changes that are very important in the current situation. Due to recession and other horrible things occurring in day to day life, we are spending fewer amounts due to lower incomes. So the products in the supermarket suffer a decline in demand. Income elasticity of demand is denoted as EI. For finding the income elasticity of demand for a good we have,
EI = (% change in quantity demanded) ï‚¸ (% change in consumers income)
EI = (% ï„Q ï‚¸ %ï„I )
= (ï„Q ï‚¸ Q) ï‚¸( ï„I ï‚¸ I)
= (ï„Q ï‚¸ ï„I) x (Iï‚¸ Q)
The sign of EI depends on the sign of ï„Q ï‚¸ ï„I.
The income elasticity of demand is mainly classified into two categories. They are
As an economic rule these categories are defined as
When the income elasticity (EI) is positive, then we say goods are normal goods.
Normal goods are said to be necessity if EI is between 0 and 1
Normal goods are said to be luxury, if EI exceeds 1
When the income elasticity (EI) is negative, then we say the goods are inferior goods.
Normal goods are any goods at which demand increases when income increases. When income changes, people either buy more of a product or change their existing products for more expensive ones. Normal goods have a positive income elasticity of demand as income increase, then demand of goods will be more at each price level. Necessities have an income elasticity of demand of between 0 and 1. Demand increases with income, but less than proportionately. This is because we have a limited need to consume additional quantities of necessary goods as our actutual living standards rise. The examples of this would be the demand for fresh vegetables, toothpaste and detergents. Inferior goods have a negative income elasticity of demand. For example if we find that the income elasticity of demand for "Absolute Vodka" in our super market is -0.3, then a 5% fall in the average real incomes of consumers might lead to a 1.5% fall in the total demand for "Absolute Vodka" (liquor available in "Prime" supermarket).
For analysis we can take chocolate as an example, the income elasticity of demand of chocolate is +1.5. When income increase by 10%, then the percentage change in demand become,
(% change in demand) = EI x (% in income change)
=1.5 x 10 = 15%
Therefore when incomes increase by 10%, demand for chocolate increases by 10%. Since demand simply increases due to change in income, then the good is defined as a normal good.When we consider the case of cheese in our super market then,
EI of Supermarket's own branded cheese = (-) 4.0 and EI of Luxury branded cheese = (+) 3.6.
When incomes increase by 10%, the demand of the supermarket's own branded cheese decreases by 40% and the demand of luxury branded cheese increases by 36% (Using the above method).
The significance of these values is that the luxury branded cheese is a superior good and the supermarket's own cheese is an inferior good. Both goods are given these names because when incomes increase, superior goods have an increase in demand and inferior goods are the goods that face a decrease in demand due to a rise in income.
Below shows some examples of income elasticity.
Normal goods:- Fresh vegitables, instant cofee, natural cheese, fruit juice, shampoo, toothpaste, detergent etc.
Inferior goods:- Frozen vegitables, processed cheese, margarine, tinned meat, own brand bread.
Luxury goods:- Fine wines, costly chocolate etc.
2.3 Cross Price Elasticity of Demand
Cross-price elasticity of demand is the responsiveness of demand for one product or service to the changes in the price of another good or service. Cross-price elasticity is calculated by dividing the percentage change in demand for one product to the percentage change in the price of its related product. The cross price elasticity is denoted as Exy. Where x and y are the two goods.
Exy = (% change in demand of good X) ï‚¸ (% change in price of good Y).
In most of the firms, managers can change price whenever they want. Managers of supermarkets will usually see a change in demand for their product in response to another firm's price change. Cross-Price elasticity is divided into three, in terms of the value obtained after finding Exy. They are
For finding whether the goods of a supermarket is substitute or independent or complement, we have a rule, that is
If Exy > 0 then the two goods are substitutes.
If Exy = 0 then the two goods are independent.
If Exy < 0 then the two goods are complements.
The Cross-Price elasticity of demand measures the rate of response of quantity demanded of one good, due to a price change in another good. If two goods are substitutes, we should expect to see consumers purchase more of one good when the price of its substitute increases. Similarly if the two goods are complements, we should see a price rise in one good cause the demand for both goods to decline. Also if the two goods are independent, then we can say there is no relation between the two goods.
For calculating the cross price elasticity of demand of the supermarket goods, we can take an example as shown below.
Table below shows the price of Pork and quantity demanded for Beef.
From the above chart we can see that when the price of pork is $9, then the quantity demanded for the beef is 150. Similarly when the price of pork increased to $10, then the quantity demanded for the beef is 190.
P (OLD) = $9, P (NEW) = $10.
Q (OLD) = 150, Q (NEW) = 190.
We have a formula for finding the percentage change in quantity demanded for beef is
[ Q (NEW) - Q (OLD) ] ï‚¸ Q (OLD)
= (190 -150) ï‚¸ 150
= 0.2666. â€¦â€¦â€¦â€¦â€¦ (a)
So percentage change in quantity demand of beef is 26.66%.
Similarly for finding the percentage change in price of pork can be calculated as
[ P (NEW) - P (OLD) ] ï‚¸ P (OLD)
= ( 10 - 9 ) ï‚¸ ( 9 )
= 0.111â€¦â€¦â€¦â€¦â€¦.. (b)
So percentage change in price of pork is 11.1%.
For finding the cross price elasticity of beef and pork is given as
EBP = (% change in demand of Beef) ï‚¸ (% change in price of Pork) â€¦â€¦â€¦â€¦â€¦.. (1)
Where suffix B is the beef and P is the pork. By substituting the values (a) and (b) in formula (1),
We get EBP = 0.2666 ï‚¸ 0.111
So we conclude that the cross price elasticity of demand for Beef when the price of Pork increases from $9 to $10 is 2.40. In this case our two goods (Beef and Pork) are substitutes, when the price of pork increases from $9 to $10.
The cross-price elasticity of demand is used to see how the demand for a good is to a price change of another good. Cross price elasticity is also applied when the demand of one good increases due to a change in price of a complement good. For example, in our supermarket we can consider two goods chicken curry ready meal and rice. If the price of chicken curry ready meal is reduced to 50%, people will buy more curry meals. So due to the increase in demand of the curry meals, it may also increase the demand for rice, that will cause a 50% increase in demand.
So ECR = (-50) ï‚¸ (50)
Thus the two products (chicken curry and rice) are the complement goods. Therefore if the price of chicken curry is reduced by 10%, the quantity demanded of rice will increase by 10%. So the cross price elasticity can be used in a more positive way if it induces a demand for its complementary good.
High positive cross-price elasticity tells us that if the price of one good goes up, the demand for the other good goes up as well. A negative tells us just the opposite, that an increase in the price of one good causes a drop in the demand for the other good. A small value (either negative or positive) tells us that there is little relation between the two goods.
Conclusion And Recommendations
By analysis of the forces or variables from the demand theory will affects the quantitative effect of the sales that are essential in order to achieve good profit and increase in total revenue for the firm for the short run and to plan for its growth in the long. A supermarket can usually set the price of commodity it sells as well as decide on the level of its expenditures on advertising, product quality and customer services. Although the firm does not have any control over the consumers growth of consumers income and price expectations or competitors pricing decision and expenditure on advertising, product quality and customer services. The firm can use the variables of the elasticity of demand to determine the best policy that are open to the firm to maximize profits or value of the firm.
If the demand for the "Prime" supermarket product is price inelastic, then the company will want to increase the product price. This increase in product price will increase the total revenue of the "Prime" and reduce the total cost. So the "Primes" profit will increase. The elasticity of the company's sales with respect to the variables beyond its control is also crucial to its ability to respond most effectively to competitors policies and to plan the best growth strategy.
Similarly, if the cross price elasticity of demand for the "Primes" production is so high, then the firm will have to respond very fast to a competitor's price reduction. Otherwise firm will be in a great risk of loosing its sales. Before reducing the price of a product, the firm has to check the risk against that of starting a price war. "Prime" also has to think of production of goods with a higher income elasticity of demand in order to benefit more from rising in future. Thus the profit and revenue can be increased only by utilizing the elasticity of all variables that a firm can obtain the best policies available to manipulate demand, to effectively respond to competitors policies and to plan its growth.