economics

Question 3 Demand elasticity is a measure of how much the quantity demanded will change if another factor changes. In proper words, it is the relative response of one variable to changes in another variable. The three main types of elasticity but only two will be discussed and they as follows: A. Income elasticity of demand (YED) Income elasticity of demand (YED) measures the relationship between a change in quantity demanded for good X and a change in real income. The formula for calculating income elasticity of demand: E =

change in quantity demanded change in income

The degree to which the quantity demanded for good changes in response to a change in income depends on whether the good is a necessity or a luxury as describe below: i.

Normal Goods

Normal goods have a positive income elasticity of demand (between 0 and +1) so as income rises more is demanded at each price level. A good example of a normal good is the type of clothes we buy. If a consumer has low income, he will buy inexpensive clothes. However when the consumer starts to earn more money he is likely to buy more expensive and branded clothes. In other words, the consumption increases as the income increases. ii.

Luxury Goods

Luxuries are items we can manage to do without during periods of below average and have an income elasticity of demand > +1. When incomes are rising strongly and consumers can make big spending, so the demand for luxury goods will grow. Conversely in a recession, customers will minimize their spending and rebuild savings.

An example of a luxury good is a round of golf. When income is low, we will not play golf. However, once income rises the consumer can afford to play golf. In other words, the increase in playing golf will be 100 percent while the increase in income may have only been 15 percent.

iii.

Inferior Goods

A type of good for which demand declines as the level of income or real GDP in the economy increases. Inferior goods have a negative income elasticity of demand. In a recession the demand for inferior products might actually grow .Transportation provides a good example of inferior goods. When income is low, consumers prefer to ride the bus. But as income increases, people stop riding the bus and start buying cars. Bus riding declines as income increases. Let’s take an example to illustrate normal goods and inferior goods. There are two commodities in the economy; flour and consumers are consuming both. Presently both commodities face a downward sloping graph, that is the higher the price the lesser will be the demand and vice versa. If the income of consumer rises, then he would be more inclined towards wheat flour which is more costly than jowar flour. Therefore, he will switch his flour demand from jowar to wheat. Hence jowar, whose demand has fallen due to an increase in income, is the inferior good and wheat is the normal good as shown below:

It should be noted that YED is used by businesses for various purposes as shown below:

1. Sales forecasting A firm can forecast the impact of a change in income on sales volume and sales revenue. For example, a car manufacturer has calculated that YED with respect to its luxury car is (+) 3.8, and it has also undertaken research to discover that consumer incomes will rise by 2% next year. It can now predict the impact of this change and increase production.

2. Pricing policy Knowing YED helps the firm decide whether to raise or lower price following a change in consumer incomes. If incomes are falling and YED is positive, a reduction in price might help compensate for the reduction in demand.

3. Diversification Firms can diversify and offer a range of goods with different YEDs to spread the risks associated with changes in the level of national income. For example, a car manufacturer may produce cars with a range of YED values, so that sales are stabilized as the economy grows and declines. 4. Economic situations Knowing the YED of a product may help a firm respond to changing economic situations and help the firm to plan ahead. If a firm is producing inferior goods, demand will increase during periods of recessions and economic downturns. Therefore, at the present moment a company may be advised to advertise its value products. This may attract customers trying to survive on a tight budget. If the economy was booming, then firms should try to promote luxury items .These good will sell better as incomes are rising. However YED is not only used by businesses. Government uses YED to solve several economic issues and helps to earn more revenue. Thus knowing the income elasticity of demand is important for government for the following reasons:

1. Consumption The income elasticity also shows us another important impact. It shows the consumption and enables the Government to make planning accordingly. The increasing income leads to rise in consumption. The best example in this case is the demand for automobiles which has been growing rapidly in the past few years. This will show the usage of fuel as well as of the road networks. This will help the government to undertake infrastructure programs in the country. The income elasticity shows which products are moving up with increased incomes and which are left behind by the consumers. 2. Tax on Savings The YED helps government to know whether to increase tax the savings of consumers or not. For example, if income is rising at high level, consumers will make savings. Government can therefore increase the tax on the savings so as to earn more revenue. Consumers will stop saving as money loses value. 3. Money Supply The YED acts as a measure to solve the problem of too much money in circulation. For example, if there is too much money in circulation, this will cause inflation. Therefore government can reduce the tax on savings and which shall in turn encourage customers to make savings and reduce circulation of money.

B. Price Elasticity of Demand (PED) According to the law of demand, the lower the price the more products are bought. Price elasticity of demand measures the responsiveness of demand to changes in price for a particular good. If the price elasticity of demand is equal to 0, demand is perfectly inelastic. Values between zero and one indicate that demand is inelastic. When price elasticity of demand equals one, demand is unit elastic. Finally, if the value is greater than one, demand is perfectly elastic. This is illustrated in the diagram below:

The following formula can be used to measure exactly how responsive demand is to a given price change:

The Algebraic terms means:

When you reduce the price of most items, people will buy more of them. For example, when supermarkets make special offers with reduced prices, they expect a sharp increase in corresponding sales. However, businesses need to have more precise information than this .They need to have a clear measure of how the quantity demanded will change as a result of a price change. For example, suppose that a supermarket reduces the price of a packaged cake from Rs1.00 to 80 cents. Say sales per week then rise from 500 to 700. Percentage change in sales = 40%, and percentage change in price = 20%.So PED = 40%/20% = 2.0.This tells us that demand for cakes is price elastic.

Let’s take another example, now suppose that the supermarket increases the price of washing up liquid from Rs1.00 to Rs1.20. Weekly sales drop only from 1,000 to 900 bottles. Percentage change in sales = 10% and percentage change in price = 20%.So PED = 10%/20% = 0.5 .This tells us that the demand for washing up liquid is price inelastic.

Generally, the more the customer has good substitutes available, the more demand will be price elastic and when there are few alternatives, demand is inelastic. There are several reasons why firms gather information about the PED of its products and they are as follows:

1. Sales forecasting Knowledge of PED can help the firm forecast its sales and set its price. The firm can forecast the impact of a change in price on its sales volume, and sales revenue For example, if PED for a product is (-) 2, a 10% reduction in price (say, from £10 to £9) will lead to a 20% increase in sales (say from 1000 to 1200). In this case, revenue will rise from £10,000 to £10,800.

2. Pricing policy While fixing the price of this product, business has to consider the elasticity of demand for the product. The firm should consider whether a lowering of price will stimulate demand for the product and if so to what extent and whether his profits will also increase a result .If the increase in his sales is more than proportionate to the reduction in price, his total revenue will increase and his profits might be larger. On the other hand, if increase in demand is less than proportionate to fall in price, his total revenue we will fall and his profits would be certainly less. 3. Shifting of tax burden To what extent a producer can shift the burden of indirect tax to the buyers by increasing price of his product depends upon the degree of elasticity of demand. If the demand is inelastic the larger part of the indirect tax can be shifted upon buyers by increasing price. On the other hand if the demand is elastic than the burden of tax will be more on the producer. 4. Price discrimination Price discrimination refers to the act of selling the technically same products at different prices to different section of consumers or in different in sub-markets. Those consumers whose demand is inelastic can be charged a higher price than those with more elastic demand.

PED is also used by government for different purposes which enable the latter to make better decisions .Below are a few purpose why PED is used by government:

1. Taxation and subsidy policy The government can impose higher taxes and collect more revenue if the demand for the commodity on which a tax is to be levied is inelastic. On the other hand, in ease of a commodity with elastic demand, high tax rates may fail to bring in the required revenue for the government. Government should provide subsidy on those goods whose demand is elastic. If the demand for hotel rooms is very inelastic, then the government can increase the sales tax on hotel rooms without creating a situation where hotels lose business and tax revenues fall. Governments will not want to raise sales taxes on items that are very elastic. Therefore, governments need to know about price elasticity of demand. 2. Importance in international trade The concept of elasticity of demand is of crucial importance in many aspects of international trade. The success of the policy of devaluation to correct the adverse balance of payment depends upon the elasticity of demand for exports and imports of the country. The policy of devaluation would be beneficial when demand for exports and imports is price elastic. A country will benefit from international trade when: i.

It fixes lower price for exports items whose demand is price elastic and high price for those exports whose demand is inelastic

ii.

The demand for imports should be inelastic for a fall in price and inelastic for arise in price. The terms of trade between the two countries also depends upon the elasticity of demand of exports and imports of two countries. If the demand is inelastic, the terms of trade will be in favor of the seller country. 3. Effect of use of machines on employment

Ordinarily it is thought that use of machines reduced the demand for labour. Therefore, government often opposes the use of machines fearing unemployment. But this fear is not always true because use of machines may not reduce demand for labour. It depends on the price elasticity of demand for the products. The use of machines may reduce the cost of production and price. If the demand of the product is elastic then the fall in price will increase demand significantly. As a result of increased demand the production will also increase and more workers will be employed. In such cases concept of elasticity of demand help the government to increase employment.

4. Public utilities The nationalization of public utility services can also be justified with the help of elasticity of demand. Demand for public utilities such as electricity, water supply etc, is generally inelastic in nature. If the operation of such utilities is left in the hand of private individuals, they may exploit the consumers by charging high prices. Therefore, in the interest of general public, the government owns and runs such services. The public utility enterprises decide their price policy on the basis of elasticity of demand.

Real world evidence shows that both income elasticity of demand and price elasticity of demand are equally necessary for businesses and government. They act as a means to make better decisions and earn more revenue.