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    Home >> Economics >> Price Elasticity Of Demand

    Price Elasticity Of Demand

    Price elasticity of demand (PED) is the responsiveness of quantity demanded of a good or service to a change in its price. Firms would be interested in knowing the price elasticity of demand as it is directly related to the total revenue of the firm. If the demand is price inelastic, them firms will increase price to raise revenue. If the demand is price elastic, then firms will decrease price. PED can help the firms estimate the effect of a price change. Firms can plan the number of goods to produce, the number of people to employ and impact on cash flow. “PED is used when price discriminating is used to set price in each market. The government can use PED to estimate the impact of an indirect tax increase in terms of sales and tax revenue. It is also used to estimate the impact on consumer spending, producers’ revenue and income of any shift in supply”.

    Income elasticity of demand (YED) is the responsiveness of quantity demanded of a good or service to change in its income. YED can determine what goods to produce or stock. It can help firms plan production and employee requirements as the company grows. It can help firms estimate any potential changes in demand as well.  For example; If the income of a country continues to grow on a long term bases, then the demand for normal goods will increase and the demand of inferior goods will decrease in ceteris paribus.

    The degree of elasticity is significant to the businesses which produce normal goods. In longer-term economic growth, industries which are associated with service sector or are the most income elastic have the potential to expand. Other businesses such as health care, education, holidays, entertainment, foreign travel are income elastic and are capable of having long-term growth.

    The conflict which persists in the less economically developed countries is that their businesses produce primary goods such as forestry, farming, fishing and mining which have low income elasticity of demand. Therefore, they only have a limited increase in the demand unlike the other manufacturing and service industries which are situated in more economically developed countries and produce elastic products. This further increases disparity between the rich and the poor countries.

    For any business, it is important for it to know the outcome or the effect of its products on the income. This can be established through a business cycle or a trade cycle. High income elasticity of demand products will have “greater swings” in demand whereas income inelastic products will have limited increase/decrease on the demand. For instance; flowers are elastic products whose demand increases during Valentine’s Day or other festivals. However, food or alcohols are not very sensitive to income. Thus, the food industries will have more stable growth than a flower business.

     

    Although the world economy is growing, the business cycle (shown above) represents the responsiveness of the products to income through booms and slumps. Although the income-elastic products’ sales increases as income increases, they are also the most prone to a fall in short-term income.

    The firms should also be aware of “the responsiveness in quantity demanded of their goods or service to the change in the price of a related good or service” or in other words cross-price elasticity of demand (CPED). The tea and coffee producers would be well aware of the cross-price elasticity of demand and the effect of the quantity demanded of their products on the price of their substitute’s business. Thus CPED is useful for firms as they can estimate the effect on their demand of a competitor’s price cut. In the case of complementary goods for example books and pencils or computers and computer programs have a direct relationship and are “very price sensitive to each other.” CPED helps firms estimate the impact on demand for their product if they cut the price of a complement. For example; if they cut the price of the laptop, how much will demand for software increase? It would be profitable for a company to buy its “rival” company or a company which sells their substitutes. In this way, they would not have to deal with a competition as “reducing the numbers of competitors makes price elasticity of demand more inelastic and gives a business more control of the market.”  Likewise, companies can also buy or collaborate with other companies who sell the complementary goods and expand through horizontal or vertical integration (when a company merges or takes over another company).

    Say perhaps Nike and Adidas are horizontally integrated companies and Nike decided to increase the price of Adidas shoes. However, Nike needs to be aware of the cross-price elasticity. If the price of Adidas shoes increases, then the quantity demanded of Adidas will decrease and Nike’s might increase as it will be cheaper than Adidas.  

    Cross price elasticity can help answer questions like “whether a proposed merger between two companies will be substantially reduce competition and therefore should be blocked” or “are the two firms highly substitutable for each other, or are they largely unrelated to one another?”

    It can be implied that the firms can easily react to changes in the market conditions through price elasticity of supply as “the factors which determine the price elasticity of supply determine the flexibility of a business towards changed market price.”

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