Test Prep: Elasticity

December 2, 2009 § Leave a comment

1. a) Define ‘Price elasticity of demand’ and explain how it is measured

The price elasticity of demand is a measure of the responsiveness of demand to a change in price. It is calculated by taking the percentage change in demand and dividing by the percentage change in price. If a good is elastic (a value for the elasticity of more than one), it is considered to be responsive to changes in price. If inelastic (a value below one) then it is unresponsive.

b) With the use of examples, explain why some products have low price elasticity while others have a high elasticity.

Inferior goods are goods where an increase in income leads to a fall in the quantity consumed. They will have a negative income elasticity of demand. e.g. used clothing (they may be substituted for more superior types).

Normal goods are goods where the demand for the good will increase as income increases. They will have a positive income elasticity of demand. For example, iPods or laptops.

Luxury goods are good where a decrease in income leads to a fall in the quantity consumed. They will have a positive income elasticity of demand. E.g. A holiday trip

1. Substitutability: Direct relationship between the number of substitute goods of a product and the elasticity of the product

2. Proportion of Income: If other things are equal, there’s a direct relationship between the price of good relative to income and the elasticity of demand of the good

3. Luxuries vs. Necessities: Necessities = inelastic, we NEED it no matter what price; ex: food. Luxuries = elastic, we can do without it; ex: Designer handbag

4. Addictiveness: If the product is very addictive (i.e. cigarettes) people will continue to buy the product regardless of price

5. Time: Short time (Less durable) to consider whether to buy a product = inelastic. No time to adjust to price change. Long time ( durable) to consider whether to buy a product = elastic. Plenty of time creates consumer sensitivity (The longer the time the more elastic the good becomes.)

c) If you were employed as an economist by a business, explain why a knowledge of the price elasticity of demand of your product would be useful.

Price elasticity of demand will allow us to analyze supply and demand with greater precision, and also, it is a measure of how much buyers and sellers respond to changes in market conditions. It is crucial to have the knowledge of a price elasticity of demand because you can use elasticity of demand data to predict the potential impact of a price change on your total sales revenues. Pricing helps drive sales revenues; it is not a cost center (unlike other marketing mix elements such as product, promotion, packaging and place/distribution)!

For example, understanding how to set prices relates to elasticity of demand. To set a price for a product or a service it is necessary to know the market and competition, know what the demand, and understand the price elasticity of demand for the product or service.

1. a) What are the various factors that determine the value of (i) price elasticity of demand and (ii) income elasticity of demand?

(i) Price elasticity of demand is a measure of the responsiveness of the demand for a product to changes in its own price. Price

elasticity of a good or service depends on a range of factors:

  • The availability of close substitutes in the market. The more substitutes available the greater the elasticity.
  • Is the good a luxury or necessity? Luxuries are more elastic in demand than necessities.

Proportion of income spent on them. Cheap items tend to have an inelastic demand.

  • Are they addictive? These obviously become price inelastic.
  • The time period. Elasticity tends to increase with time.
  • Number of uses

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