DEMAND THEORY AND ELASTICITY

Demand Elasticity

DEMAND THEORY AND ELASTICITY

I write a summary about demand theory and elasticity based on Keat, P. and Phillip Young. 2008. Managerial Economics, 6th edition. Pearson (KY) e-book.

Demand is one of the most important aspects of managerial economics on the firm since the business would not establish or survive if a sufficient demand for its product or service did not exist or could not be created. The company should have analysis measurements about the responsiveness in the quantity of demand of a commodity to changes in each of the forces that determine demand.

The demand for products faced by firms differs on the market, thus, to understand the market demand, the company should examine the consumer demand for the first time. Consumer demand theory postulates that the quantity demanded of a commodity is a function of or depends on, the price of the commodity, the consumer’s income, the price of related commodities, and the taste of the consumer.

Individual Demand Commodity

The figure above describes an individual’s demand schedule for commodity x. At the price of $2, the individual purchases 1 unit, 3 units if the price is $3, and 4.5 units if the price is $0.5. The change in price commodity x will affect the quantity of demand inversely The increasing price encourages customers to buy alternative products.

This effect called a substitution effect that measures how much the higher price encourages consumers to buy substitute products at the same level of income. When the price of a commodity falls, the consumer can buy more products due to an increase in disposable income and it called the income effect. The market demand curve is simply the horizontal summation of the demand curves of all the consumers in the market.

The Price Elasticity of Demand : Arc Elasticity Formula

The responsiveness in the number of demand changes affected by price is important to the firm. The lowering price of the commodity can increase the sales of the company due to the increase in demand. However, the lowering price can reduce company revenue and affected production costs and company profitability. This effect related to the sensitivity of the change in the quantity of demand is to change in price (price elasticity of demand).

To measure the price elasticity we can use Arc price elasticity formula that measures the demand between two points on the demand curve. For example, the initial price is $4 with a quantity of demand 200 and fell to $3 with the quantity of demand 300, so the price elasticity :

In other cases if the price increase from $3 with the quantity of demand 300 to $4 with the quantity of demand 200, the calculation will be :

The changes for increasing/decreasing $1 price not express the same changes point, we should use the average of the two prices and the average of the quantities in the calculation. The formulation is :

Analysis

The result of the reverse movement will be the same. This calculation means a 1 percent change in the result on average in a 1.4 percent opposite change in the quantity demanded of commodity x. The price elasticity of the demand curve that a firm face is larger than the price elasticity of the corresponding market demand curve because the firm faces competition from similar commodities from rival firms. Price elasticity has an important role in the total revenue of the company.

As stated before in the first paragraph, the change in the price of products can affect the demand for quantity and revenue. The total revenue (TR) is equal to Price (P) times quantity (Q), and we can calculate the change in total revenue (TR) per unit change in sales or called Marginal Revenue (MR).

Read : Market Equilibrium

Correlation between Price Elasticity, Total Revenue and Marginal Revenue

The total revenue will increase with a decrease in price if the demand is elastic (Ep > 1) when the price decline leads to a proportionally larger increase in quantity demand. The total revenue will remains if demand is unitary elastic (Ep=1). A decline in price leads to an equal proportionate increase in quantity demanded and total revenue remains unchanged. The total will decrease if demand is inelastic (Ep<1), when a decline in price leads to a smaller proportionate increase in quantity demanded, and so the total revenue of the firm declines.

Price Elasticity for Commodity

The price elasticity of demand for a commodity depends primarily on the availability of the substitutes for the commodity but also on the length of time over which the quantity response to the price change is measured. The more narrowly a commodity is defined, the greater is its price elasticity of demand because the greater will be the number of substitutes.

The price elasticity of demand is also larger is the period allowed for consumers to respond to the change in the commodity price. The reason is that it usually takes some time for consumers to learn of the availability of substitutes and to adjust their purchases to the price change.

Income Elasticity of Demand

Alongside price, the level of consumer income is very important to the determinant of demand. The responsiveness in the demand for a commodity to a change in consumer income is called by income elasticity of demand (EI). We can measure the income elasticity of demand by point income elasticity of demand formula :

Cross-Price Elasticity of Demand

The demand for a commodity also depends on the price of related commodities. We can measure the responsiveness in the demand for commodity x to change in the price of commodity y, holding constant all the other variables in the demand function, including income and the price of commodity x. The formula is point cross-price elasticity of demand given by :

If the value of Exy is positive, commodities X and Y are substitutes because an increase in Py leads to an increase in Qx as X is substituted for Y consumption. If the value of Exy is negative, commodities X and Y are complementary because an increase in Py leads to a reduction in Qr and Qx. The absolute value of Exy measures the degree of substitutability and complementarity between X and Y. The cross-price elasticity of demand is a very important concept in managerial decisions making.

Firms often use this concept to measure the effect of changing the price of a product they sell on the demand for other related products that the firm also sells. A high positive cross-price elasticity of demand is often used to define as an industry since it indicates that various commodities are very similar.

Elasticity for Managerial Decision Making

The company uses elasticity analysis to make the best operating decision and to plan company growth. Here is the elasticities analysis role on managerial decision making :

  • A company can set the price of the commodity to sells. Decide the budgeting cost of marketing, quality product, consumer service but has no control over the level of growing consumer income, pricing decision, and consumer price expectation.
  • The firm needs these elasticity estimates to optimize operational policies and the most effective way to respond to the policies of competing firms.
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