Consider a product that you have purchased recently. If the price of this item i
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Question
Consider a product that you have purchased recently. If the price of this item increases, how would you adjust your purchases? Is the Demand for this product Price Elastic or Price Inelastic ? Justify your classification by applying the determinants of elasticity to this product. Suppose price of this product is on the rise and you are the store manager, Would you be thrilled to be selling this product? How does an increase in price for this product affect your Total Revenue? Using specific examples relate concepts of Cross Elasticity and Income Elasticity to this product.Explanation / Answer
When the price of a product increases it reduces the purchasing power of the budget so that fewer other items can now be purchased. Since the budget is usually fixed, the product whose price has increased is purchased less so we say that the quantity demanded has fallen. But how much it has fallen depends on the several factors, as accounted by the price elasticity.
Price elasticity of demand (own)
Price elasticity of demand is the measure of responsiveness of change in the quantity of a product demanded as its price changes.
Price elasticity of demand for a product depends on many factors, and not just the price of a product itself. When any of these factors changes, it tends to influence the elasticity of the product. Availability of close substitutes, income of the consumer and the presence of complements all tend to affect the demand for a product, besides its own price.
Cross price elasticity of demand
For a product X, the cross price elasticity of its demand is a measure of responsiveness of change in its demand for any given change in the price of its related product Y. Symbolically, this implies.
Cross-price elasticity of demand for a product is positive for its substitutes, negative for its complements and zero for the goods unrelated to it.
Total revenue and price elasticity
The effect of a price change on the total revenues earned can be assessed by investigating the relationship between price elasticity and total revenue. Total revenue rises with a rise in price when price elasticity is less than one. This implies total revenue will rise if prices are increased, when the demand is relatively inelastic.
Numerical example:
Observe the demand function for Product A, given by QA = 10 – 5PA+ 2PB+ 0.01I
Note that the demand depends on its own price PA, as well as on two other variables, the price of related good, PBand the income of the consumer I.
The initial values are QA= 15, PA= $4, PB= $2.5 and I = $2,000. Plug-in them in the demand function:
QA = 10 - 5PA+ 2PB+ 0.01I
= 10 – 5(4) +2(2.5) + 0.01(2,000)
= 10 – 20 + 5 + 20
= 15
Hence, the initial demand is 15 units
Own price elasticity of demand is the measure of responsiveness of change in the quantity of a product demanded as its price changes. Consider the formula for own price elasticity of a product
ed = %change in Qd/% change in price.
In the case given, assume that price changes from $4 to $3.4, so there is a fall of 15%. The quantity demanded, as a result rises from 15 to 18 (you can find this by placing PA = 3.4 in demand equation), thus, showing a rise of 20%.
Hence, the own price elasticity of demand for product A is -20/15 or -1.33
Income elasticity of demand for product A is the measure of responsiveness of change in the quantity of product A demanded as the income changes.
When the income, I, increases to from $2,000 to $2,250 per period thus showing an increase of 12.5%, QA increase from 15 units to 17.5 units, displaying an increase of 16%.
Hence, the income elasticity of demand for product A 16/12.5 or is 1.28. Income elasticity of demand for A is 1.28 (the sign is positive – when income increases, the demand also increases). This implies that Product A is a normal good.
Cross price elasticity of demand is the measure of responsiveness of change in the quantity of a product demanded as its price of its related good changes.
In the case given, the price of the substitute good changes from $2.5 to $3, thereby showing a rise of 20%. The quantity demanded, as a result rises from 15 to 16, thus, exhibiting a rise of 6.6%.
Hence, the cross price elasticity of demand for product A is 6.6/20 is 0.33. The sign of the coefficient of variable PB suggests that product B has a positive cross price elasticity.
This implies that the product B is a substitute of product A.
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