Economics Model Essay 1

This question will be discussed in economics tuition in the fifth week of term 1.

(a) Distinguish between the concepts of price elasticity of demand, income elasticity of demand and cross elasticity of demand. [10]
(b) Discuss the usefulness of the concepts of elasticity of demand to a firm that produces a fashionable product. [15]

Answer

Introduction

(a) The elasticity of demand for a good is a measure of the degree of responsiveness of the quantity demanded or the demand to a change in a determinant of demand, ceteris paribus. There are three concepts of elasticity of demand each relating to one of the determinants of demand: price elasticity of demand (PED), income elasticity of demand (YED) and cross elasticity of demand (XED).

Definitions and Formulas

There are different definitions and formulas for PED, YED and XED. The PED for a good is a measure of the degree of responsiveness of the quantity demanded to a change in the price, ceteris paribus. Mathematically, it can be expressed as

           % Δ Quantity Demanded
PED = ————————————-
% Δ Price

The YED for a good is a measure of the degree of responsiveness of the demand to a change in income, ceteris paribus. Mathematically, it can be expressed as

         % Δ Demand
YED = ———————–
% Δ Income

The XED for a good with respect to another good is a measure of the degree of responsiveness of the demand for the first good to a change in the price of the second good, ceteris paribus. Suppose that the two goods are good A and good B. Mathematically, it can be expressed as

         % Δ Demand for Good A
XEDAB = ————————————–
% Δ Price of Good B

Interpretation of the Values of PED, YED and XED

There are different implications of the values of PED, YED and XED. The PED for a good is negative due to the law of demand and the common practice among economists is to drop the negative sign. If the PED for a good is greater than one, such as in the case of private cars, the demand is price elastic, which means that a change in the price will lead to a larger percentage change in the quantity demanded. If the PED for a good is less than one, such as in the case of food, the demand is price inelastic, which means that a change in the price will lead to a smaller percentage change in the quantity demanded. In the case of PED, economists are concerned with whether the value is greater or less than one. However, in the case of XED, they look at whether the value is positive or negative. If the XEDAB is positive, such as in the case of Coke and Pepsi, good A and good B are substitutes, which means that the two goods are consumed in place of one another. If the XEDAB is negative, such as in the case of cars and petrol, good A and good B are complements, which means that the two goods are consumed in conjunction with one another. While XED distinguishes between substitutes and complements, YED distinguishes between normal goods and inferior goods. If the YED for a good is positive, such as in the case of clothing, the demand will rise when consumers’ income rises and goods of this nature are known as normal goods. A normal good with a YED greater than one is known as a luxury and a normal good with a YED less than one is known as a necessity. If the YED for a good is negative, such as in the case of public transport, the demand will fall when consumers’ income rises and goods of this nature are known as inferior goods.

Determinants of PED, YED and XED

There are different determinants of PED, YED and XED. The PED for a good will be higher the larger the number of substitutes, the closer the substitutes, the lower the degree of necessity, the larger the proportion of income spent on the good and the longer the time period under consideration. For example, the demand for a brand of smartphones is likely to be price elastic due to the large number of substitutes, the demand for oil is price inelastic due to the high degree of necessity and lack of close substitutes and the demand for private cars is likely to be price elastic due to the large proportion of income spent on the goods as they are generally expensive. The YED for a good will be higher the more luxurious the good and the lower the level of income. For example, the YED for high-end private cars is higher than those for mid-range and low-end private cars as high-end private cars are more luxurious than mid-range and low-end private cars, and the YED for private cars in the Philippines is higher than that in Singapore as the level of income in the Philippines is lower than that in Singapore. The XED for two goods will be higher the more closely they are related. For example, the XED for Coke and Pepsi is higher than that between coffee and tea as Coke and Pepsi are closer substitutes than coffee and tea are.

Conclusion

In conclusion, PED, YED and XED differ in terms of their definitions, formulas, determinants and the implications of their values.

Answer

Introduction

(b) The usefulness of the concepts of elasticity of demand to a firm that produces a fashionable product can be discussed in terms of how they can aid the firm in making pricing and capacity decisions with reference to price elasticity of demand, cross elasticity of demand and income elasticity of demand. Assume that the fashionable product is smartphones.

Usefulness of the Concept of PED

The concept of PED allows a firm that produces smartphones to determine how to change the price to increase the total revenue. The demand for smartphones produced by a firm is likely to be price elastic due to the large number of substitute brands in the market such as Apple, Samsung, LG, HTC, Sony, BlackBerry, etc. Therefore, the firm can decrease the price to increase the total revenue as the quantity demanded will rise by a larger percentage.

In the above diagram, the initial total revenue is area A plus area B and the new total revenue is area B plus area C. Area C is the gain in revenue resulting from the increase in the quantity demanded (Q) from Q0 to Q1 and area A is the loss in revenue resulting from the fall in the price (P) from P0 to P1. Since area C is greater than area A, the gain in revenue exceeds the loss and hence the total revenue rises. However, if the firm has no or little excess capacity or if rival firms follow suit in order to avoid losing sales to the first firm, a fall in its price may not lead to an increase in its total revenue. Although the demand for smartphones produced by a firm is likely to be price elastic, it may be price inelastic because the smartphones may have some special features that are not found on other smartphones. For example, Apple’s smartphones have voice recognition and fingerprint-password authentication features which many other smartphones do not include. In this case, the firm can increase the price to increase the total revenue as the quantity demanded will fall by a smaller percentage.

In the above diagram, the initial total revenue is area B plus area C and the new total revenue is area A plus area B. Area A is the gain in revenue resulting from the rise in the price (P) from P0 to P1 and area C is the loss in revenue resulting from the decrease in the quantity demanded (Q) from Q0 to Q1. Since area A is greater than area C, the gain in revenue exceeds the loss and hence the total revenue rises. However, if the firm also sells a complementary good, such as applications for the smartphones, due to the negative XED for complements, a rise in the price of its smartphones will decrease its revenue from the sale of the applications which may lead to a decrease in its total revenue. For example, in addition to smartphones, Apple Corporation also sells applications for its smartphones.

Usefulness of the Concept of XED

The concept of XED also allows a firm that produces smartphones to determine how a change in price by a rival firm will affect the demand for its good. If a rival firm decreases its price, the demand for the smartphones produced by the first firm will fall due to the positive XED for substitutes. To avoid a decrease in sales, the firm may need to decrease its price. However, if this is likely to lead to a price war, the firm may consider engaging in non-price competition such as product promotion and product development instead of decreasing its price. If a rival firm increases its price, the demand for the smartphones produced by the first firm will increase if it keeps its price constant. However, the firm may not experience an increase in sales if it has no or little excess capacity.

Usefulness of the Concept of YED

The concept of YED allows a firm that produces smartphones to determine the future size of the market for its good and hence its production capacity. The YED for smartphones is positive which means that they are a normal good. Therefore, if a firm that produces smartphones predicts an economic expansion which is a period of time during which national output and hence national income is rising, it should increase its production capacity in order to be able to meet the higher demand when the economic expansion comes. Furthermore, the higher the YED is, the larger will be the increase in the demand and hence the larger the extent the firm should increase its production capacity. Conversely, if the firm predicts an economic contraction which is a period of time during which national output and hence national income is falling, it should decrease its production capacity to minimise excess capacity when the economic contraction comes.

Limitations of the Concepts of Elasticity of Demand

The concepts of elasticity of demand may not be useful to a firm that produces smartphones as they are subject to several limitations. The data that are used to calculate elasticities of demand may be irrelevant or unreliable. Data from past records may no longer be relevant to calculating elasticities of demand as some of the determinants of demand may have changed. Although data from current market surveys are relevant to calculating elasticities of demand, they may not be reliable as the respondents may not be truthful in their responses. Furthermore, if the sample sizes of the market surveys are small, the results may not be reliable as they may not be reflective of the actual markets for the goods. The assumption of ceteris paribus that is made in calculating elasticities of demand is unlikely to hold in reality. In reality, many factors such as the level of income, the price of the good and the prices of related goods are changing simultaneously. Although PED may be useful for increasing total revenue, this is not true for increasing profit due to the omission of total cost. For example, if demand is price elastic, a fall in price will lead to a larger proportionate increase in quantity demanded resulting in an increase in total revenue. However, if total cost rises by a larger extent, profit will fall. PED and XED do not take production capacity into consideration. For example, if demand is price elastic, a fall in price will lead to a larger proportionate increase in quantity demanded resulting in an increase in total revenue. However, total revenue will not rise if there is no excess capacity to increase production.

Evaluation

In the final analysis, for a firm that produces a fashionable product such as smartphones, PED is likely to be more useful than YED and XED for making business decisions. This is because although PED can be useful for making proactive business decisions which is of great importance in the business world, YED and XED can only be useful for making reactive business decisions. In other words, unlike the use of PED which does not have a precondition, the use of YED and XED requires a change in consumers’ income and the price of a related good respectively. However, if the firm also sells a complementary good such as applications for the smartphones, XED can also be useful for making proactive business decisions which has been explained earlier. Although PED can be more useful than YED and XED to a firm that produces a fashionable product such as smartphones for making business decisions, its usefulness depends on several factors such as the objective of the firm. For example, if a firm wants to increase sales revenue as it is the key performance indicator of the management, PED is likely to be useful. However, if a firm is a new entrant in the market, it may want to increase market share to compete with the incumbent firms. In this case, PED is likely to be of limited use to the firm. For example, when StarHub entered the telecommunications market in Singapore in 2000, its initial objective was to induce mobile phone users to switch service providers so that it could capture sufficient market share to compete with SingTel and M1.

The question will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

Author’s comments

Part A

Students simply need to distinguish between the concepts of price elasticity of demand, income elasticity of demand and cross elasticity of demand in terms of the definitions, the formulas, the implications of the values and the determinants.

Students should use comparing and contrasting words like ‘while’, ‘but’ ‘like’, ‘unlike’ and ‘however’ to show an attempt to distinguish between the concepts.

Students should give examples for the different values of the three concepts of elasticity of demand.

Part B

Students simply need to explain the usefulness of the concepts of elasticity of demand to a firm that produces a fashionable product in terms of how they can aid the firm in making pricing and capacity decisions with reference to price elasticity of demand, cross elasticity of demand and income elasticity of demand.

A fashionable product is a rather broadly defined good. Therefore, students should narrow the definition to make the question manageable. For this purpose, I assume that the fashionable product is smartphones.

Students should understand that there is a difference between the PED for smartphones and the PED for smartphones produced by a firm. Although the former is likely to be less than one, the latter is likely to be greater than one.

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