Elasticity

1. Describe Marshallian Demand and Supply Theory: Demand is the quantity of a good buyers wish to purchase at each conceivable price (Begg, 1984, p.45). Supply is the quantity of a good sellers wish to purchase at each conceivable price (Begg, 1984, p.45) According to Mathews (2005, p.55), there is the law of demand: “Other things remain the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded.” Mathews (2005, p.60) also states the law of supply: “Other things remain the same, the higher the price a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied.” However, demand and supplies are not distinct, it works together in a market. Mankiw & Taylor (2006, p.63) defined market is “a group of buyers and sellers of a particular good or service”. In other words, the market brings producers and consumers get together and exchange goods or services. Ideally, all what are supplied should be consumed. At that time, the market is equilibrium. Price Equilibrium Price Equilibrium Quantity Quantity Demand Supply Equilibrium Figure 1: The equilibrium of supply and demand The point at which demand curve cuts supply curve is called the market’s equilibrium. According to Mankiw & Taylor (2006, p.74), “the equilibrium price is sometimes called the market-clearing price because, at this price, everyone in the market has been satisfied: buyers have bought all they want to buy, and sellers have sold all they want to sell” However, demand and supply are affected by many other elements, such as, price of substitute goods, technology, consumers’ income, therefore, market is often not equilibrium. Figure 2: Excess supply Surplus (Excess supply) Demand Supply Price Quantity When the supply exceeds demand, there is surplus of supply in the market. There are many products produced but consumers do not want to buy. E When demand exceeds supply, it is called shortage. Consumers want to purchase more products than products produced. Demand Supply Price Quantity Shortage (Excess demand) Figure 3: Excess demand E In competitive market, surplus or shortage does not exist for a long time. When the market is in surplus situation, producers will decrease the price to sell their goods or services. When the market is excess in demand, suppliers will certainly increase their price to sell and make more profit. As a result, prices eventually move toward the equilibrium point (E). 2. Discuss why an understanding of demand elasticity is important to the management task' Elasticity is a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants. (Mankiw & Taylor, 2006, p.88) Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by percentage change in price. (Mankiw & Taylor, 2006, p.88) Price elasticity is very important for manager to make decision because it can affect total revenue. Total revenue (TR) is “the amount paid by buyers and received by sellers of the good, computed as the price of good times the quantity sold” (Mankiw & Taylor, 2006, p.92) TR = Price x Quantity sold = P x Q The price (P) and quantity (Q) are two core factors that make up total revenue. Therefore, any change in price or quantity will influence total revenue. However, these changes are calculated by Price elasticity of demand (Ed). * “When demand is inelastic (a price elasticity less than 1), price and total revenue move in the same direction” (Mankiw & Taylor, 2006, p.94) In this case, if the price increases, it will result in higher total revenue. In contrast, the price decrease will result in lower total revenue. Why' When the price rises, products or services will be probably sold less. However, the decrease in quantity demanded is relative small, therefore the total revenue still increase. This trend is clearly illustrated in the following graph: Figure 4: Revenue when demand is inelastic Q For example, if First Transforming Travel Company changes the price from £3 to £4 for a return ticket fare to university, some students may walk to school. When the price is £3, the number of passengers for a month is 6000. However, when the price is £4, the total number of passengers might decrease to 5700. The calculation for total revenue: TR before increasing price: £3 x 6000 = £18000 TR after increasing price: £4 x 5700 = £22800 Revenue Loss because of a decrease in quantity: (6000 – 5700) x3 = £900 Revenue gain from a rise in price: (4 – 3) x 5700 = £5700 Revenue Gain > Revenue Loss 4 3 £900 Loss £5700 Gain Price Quantity 5700 6000 Revenue gain: £5700 - £900 = 4800 = £22800 - £18000 £ Figure 5: Revenue of First Transforming Travel * “When demand is elastic (a price elasticity greater than 1), price and total revenue move in opposite direction” (Mankiw & Taylor, 2006, p.94). In this situation, the higher price is, the lower total revenue is. The changes in price will cause a larger amount in total revenue. For instance, the price increase by 10%, a company will lose more than 10% of their business. Although sellers get more money for each unit they sell, the total amount of items sold is much fewer. Example: A owener of a butcher’s wants to increase the total revenue. He/ she decides increase price for 1kg of beef from 5£ to £7. After 1 month, the quantity sold decrease from 500 to 300 -> the profit decrease. Why' The calculation for total revenue: TR before increasing price: £5 x 500 = £2500 TR after increasing price: £7 x 300 = £2100 Revenue loss because of a decrease in quantity: (500 - 300) x 5 = £1000 Revenue gain from a rise in price: (7 – 5) x 300 = £600 Revenue Loss > Revenue Gain Revenue Loss: £1000 - £600 = £300 = £2500 - £2100 £1000 Loss £7 Price £5 300 500 Quantity £600 Gain Figure 6: Revenue of the butcher’s * “If demand is unit elastic (a price elasticity exactly equal to 1), total revenue remains constant when the price changes” (Mankiw & Taylor, 2006, p.94) Unit elasticity does not cause any change on total revenue. When demand is unit elastic, percentage change in quantity exactly equals to percentage change in price, therefore, total revenue remains constant. * By considering the relationship between price elasticity of demand and total revenue, manager can draw a suitable pricing strategy. It is extremely important to managers to know that their products or services are inelastic or elastic because they can know what happens if the price change. According to Jobber & Fahy (2009, p.193), “the price of the product is what the company gets back in return for all the effort that is put in to manufacturing and marketing the product.”, therefore setting price is very importtant in business. When the price change, it will lead to a change in quantity demanded. Managers need to understand how much consumers response to the change in price to decide if it is necessary to change the price. To understand elasticity, managers also need consider what determines elasticity. Farnham (2005, p.58) list 4 major factors influence the price elasticity of demand: * The number of subtitute goods * The percent of consumer’s income that is spent on product * The time period under consideration * The nature of good (i.e., whether it is durable or nondurable) 3. Is it the case that an increase in price will always result in a lowering of quantity demanded' It is believed that an increase in price will not always lead to a lowering of quantity demanded. There are several forces can determine the quantity of demand, such as preferences of consumers, income, types of goods and price of other goods. * Consumer preferences: Petersen & Lewis (1990, p.127) indicates that preference of consumers is an important determinant of demand. They argue that preferences “can change rapidly in response to advertising, fads and customs”, that is why organisations have to keep doing promotion. Advertising plays an important role. It not only makes customers know about new products but also influence customers’ decision making. An example of this is endorsement advertising. This technique refers to using celebrities or famous people to endorse a product or service. For instance, teenagers buy more products of Disney because these products are endorsed by their idols, such as Hannah Montana, Jonas Brother and Selena Gomez. * Although the price rises, if the consumers are willing to buy, the quantity demanded still rise. * Income: Petersen & Lewis (1990, p.127) have pointed out that “for most goods, an increase in consumer income would cause the demand curve for the product to shift to the right”. However, it also depends on what type of the good. Mankiw & Taylor (2006, p.69 & p.97) categorise goods related to income; these are: normal good, inferior goods and luxury goods. With normal and luxury goods, consumers tend to buy more if their income rises. On the other hand, the demand for inferior goods might decrease. For example, if people are paid higher salary, they might buy a car that is more expensive rather than buying a cheap one. * If the price of products or services increase, however, consumers still can afford products or services, quantity demanded might increase. * Types of goods: There are three main types of goods related to price, namely normal goods, Giffen goods and Veblen goods. Most goods are normal goods. There is a general trend in demand of normal goods: an increase in price will lead to a decrease in quantity. However, when the price goes up, giffen goods are consumed more. An example of this is the famine occurred in Ireland, when the price of potato rose, poor people bought more potatoes because they thought that the price would be increasing. There is the same direction between price and Veblen goods’ demand. The higher price is, the more quantity demanded. This is because Veblen goods, also known as status goods, the value of these products based on how expensive they are. For example, although Louis Vuitton increase the price of products, people are willing to buy because they want to donate their status by using the Louis Vuitton bags. * An increase in price will cause a decrease in quantity demanded is only right for normal goods. * Prices of other goods: Quantity demanded also depends on the changes in prices of other goods. “The nature of the impact depends on whether the goods are substitutes or complements” (Petersen & Lewis, 1990, p.127) D D D’ D’ Price Quantity Demand of a product or service rises if the prices of its substitutes rise. “Substitutes are often pairs of goods that are used in place of each other” (Mankiw & Taylor, 2006, p68). For instance, if Mc Donalds increase their price, customers would buy Burger King. Therefore, the Burger King’s demand curve will shift to the right, from DD to D’D’: Figure 7: Shift of demand of Burger King Demand of a product or service would fall if the price of its complement rises. “Complements are often a pair of goods that are used together” (Mankiw & Taylor, 2006, p68). For example, if the price of a cinema ticket rises, fewer people would go to the cinema, therefore, the demand of popcorn sold in the cinema would decrease. The demand curve will shift to the left, from DD to D’D’: D D D’ D’ Price Quantity Figure 8: Shift of demand for popcorn If the price goes up, the quantity demanded probably decline in condition that the prices of substitutes do not increase or the price of its complements increase.