A. Define the following three terms:
Elasticity of demand
This refers to the degree to which the demand for a commodity varies with the variation in its price. In normal circumstances, the reduction in price of a good or service results in an increased demand for that particular commodity (Hoxie 2010). It also refers to the responsiveness of demand for a commodity as a result of changes in its price.
This measures the rate at which the quantity of a product demanded responds to the changes in the price of another related good. For instance, if the price of a product increases, the demand for the substitutes to this good or service will eventually increase as the demand for the product whose price rose goes down (Hoxie 2010). If these two goods are complementary, the rise in price of one commodity would result in reduced demand for both commodities.
This is the measure of the rate at which the quantity demanded of a product responds to the changes in the income levels of consumers. It is calculated using the following formula
YED = (% Change in Quantity Demanded)/ (% Change in Income)
The responsiveness of demand in this case depends on whether the commodity is a normal good or an inferior good (Hoxie 2010).
B. Explain the elasticity coefficients for each of the three terms defined in part A.
Price elasticity coefficient is the numerical measure of the relative response of the demand for a commodity with the increase or decrease of its price. When this ratio is greater than 1, the demand is said to be elastic. If the ratio is equal 1, we have unit elastic, and if it is less than 1, the demand is said to be inelastic.
Cross-prices elasticity coefficient is percentage ratio of the change in the demanded quantity of a product with the change in the price of related goods such as substitutes and complementary (Hoxie 2010). If this coefficient is positive, then the two commodities are substitutes and if it is negative, the two goods are complementary goods.
Income elasticity coefficient is the percentage ratio of the variation of the demand of commodities with variations in the income of the consumers. Normal goods posses’ positive coefficient while that of the inferior products is negative.C. Contrast the terms defined in part A.
The three terms are different from one another. Price elasticity of demand measures the responsiveness of demand to the changes in the price of a commodity. Cross-price elasticity measures responsiveness of demand as a result of change in the price of a related commodity. Income elasticity on its part measures the responsiveness of demand for a commodity as a result of change in the income of a consumer.
Explain the significance of differences among the three terms you contrasted in part C.
The price elasticity of demand measures the variations in the price of a commodity with the variations in its price while cost price elasticity compares the prices of two related commodities such as complements and substitutes. The income elasticity measures this variation in relation to the income of the consumers, and not the prices of these products. The significance of this difference is that, it makes managers to make well informed decisions concerning the demand of a product (Hoxie 2010). Therefore, decision makers in the firms make good decisions when planning for the firm.
D. Explain whether demand would tend to be more or less elastic for each of the following three determinants of elasticity demand:
1. Availability of substitutes
In a short-term effect, cheaper or superior substitutes will reduce the demand for a product. However, in the long-term effect, the producers of the commodity whose demand has fallen would adjust to competition by either adding value or reducing the price for their commodities. Therefore, when substitutes are available for a product, the demand would be elastic.
2. Share of consumer income devoted to a good
The share of the consumers’ income that they will to spend on a good or a service determines income elasticity of the demand of that commodity. The effect of the share of the consumer’s income, which is devoted to a good on the income elasticity, depends on whether a good is normal or inferior (Hoxie 2010). For a normal good, the increase in this share increases elasticity meaning that such a good is more responsive while for an inferior good; this increase reduces the demand hence this demand is less elastic or inelastic.
3. Consumer’s time horizon
This refers to the time consumers take to adjust to changes in the prices of commodities. If consumers have enough time to adjust to these changes in price, the demand will be highly elastic, while it will be less inelastic over a short horizon time.
E. Provide an example for each of the three determinants in part D
When the price of 500g margarine from shop X is $10 and shop Y sells the same quantity at $8, the consumers would shift to buy from shop Y since it provides a cheaper substitute. This shifts results to cross price elasticity of demand.
When consumers devote more of their income on a certain commodity, the demand for such a commodity will be more elastic. However, this will depend on whether that good is normal or inferior. When consumers have enough time to shop around, this leads the demand for a commodity to be more responsive hence more elastic.
Explain the logical impacts to business decision making that result from each of the examples you provided in part E
Managers usually make decisions about the price to charge on the products that they offer in the market. Therefore, they use cross price elasticity to make decisions on whether to increase or decrease prices of two commodities that are related. For instance, the increase in the price of coffee will have an effect on the demand for tea; hence these managers utilize the concept of cross price elasticity to make informed decisions in the firm.
The second example is about the concept of income elasticity of demand. Consumers’ devotion of incomes to certain commodities depends on the economic fluctuations experienced in a country. Therefore, this helps managers to make production decisions based on the various business cycles that an economy goes through.
Finally, the third example helps the decision makers in a firm to make well informed advertising decisions that are crucial to give a consumer enough time to make decisions on products to buy.
F. Differentiate between perfectly inelastic demand and perfectly elastic demand
Illustrate the difference between the terms in part F with specific descriptions or graphs.
Perfectly inelastic demand refers to a situation whereby the quantities of a product demanded fail to respond to the changes in price. Perfectly inelastic demand occurs for necessities, which must be consumed by the consumers despite their price variations. It also applies for goods of ostentation where the higher the prices of commodities move, the more they become prestigious and therefore, more attractive.
The above graph shows that the demand would always remain constant despite the increase in demand for a commodity.
On the other hand, perfectly elastic demand is a situation whereby, the slightest changes in the prices of a product results in noticeable change in the quantities demanded of that particular product (Hoxie 2010). When these prices rise, the consumers would resort to substitutes thereby reducing the demand of a particular product. However, when the prices fall, the demand of this product will eventually rise. Due to the infinite responsiveness of the demand to the changes in price, the resulting curve is always a flat demand curve.
The above graph shows the infinite responsiveness of demand to the changes in price
G. Explain the Relationship Between Elasticity of Demand and Total Revenue for the Following Ranges Along the Demand Curve, Using the Attached "Graphs for Elasticity of Demand, Total Revenue." Include the Impacts to Quantity Demanded and Total Revenue When There is a Price Decrease, Ceteris Paribus
Elasticity of demand = increase in quantity demanded / % increase in price
Total revenue = P*Q1. Elastic Range
In the elastic range, a percentage change in price translates into a higher percentage change in quantity; therefore, a price decrease will cause a relatively higher quantity increase. The increase in the quantity demanded will compensate the price decrease, so the total revenue will increase too.2. Inelastic Range
In the inelastic range, a percentage change in price translates into a lower percentage change in quantity; therefore, a price decrease will cause a relatively lower quantity increase. The increase in the quantity demanded will not compensate the price decrease, so the total revenue will decrease.
3. Unit-Elastic Range
The price decrease will be exactly compensated by the increase of the quantity demanded, so the total revenue will remain the same.
Hoxie R. F. (2010). The Demand and Supply Concepts: An Introduction to the Study of Market Price (1906). Whitefish, Montana: Kessinger Publishing.