Question

According to the law of demand, if price increases, quantity demanded of a good or service will decrease or vice versa. Price elasticity of demand tells us how much quantity demanded will decrease when price increases or how much quantity demanded will increase if price decreases.On the other hand, according to the law of supply, if the price increases, quantity supplied of a good or service will increase. Similarly, if price decreases, quantity supplied will decrease. The degree of sensitivity (responsiveness) of production/supply to a change in price is measured by the concept of price elasticity of supply.Total revenue is calculated as the quantity of a good or service sold multiplied by its market price. Thus, it is a measure of how much money a company makes from selling its product. The core objective of a firm is maximizing profit. One of the ways to maximize profit is increasing total revenue. The firm can increase its total revenue by selling more items or by raising the price. Among others, this depends on the nature of the price elasticity of demand. Moreover, the length of time is an important factor in determining price elasticity of demand and supply.

Explain the relationship between the price elasticity of demand and total revenue. What are the impacts of various forms of elasticities (elastic, inelastic, unit elastic, etc.) on business decisions and strategies to maximize profit? Explain your responses using empirical examples, formulas, and graphs.

● Is the price elasticity of demand or supply more elastic over a shorter or a longer period of time? Why? Give examples.

● What are the impacts of government and market imperfections (failures) on the price elasticities of demand and supply?

please list any references used

Answer 1

To explain the behavior of consumers and producers better, economists introduced the concepts of supply and demand as consumers and producers behave differently. In short, the law of demand states that with price increase quantity demanded of a good or services decreases, and the law of supply states that quantity of a good produced increase if the market price of that good increases. Of course, it is just general rule and does not explain all varieties of factors impacting the supply and demand model. There for, the quantitative measurement such as elasticity was introduced to provide more detail about market behavior. Price elasticity describes what happens to the demand for a product as its price changes. If the prices for the product rise the demands will decrease. Price elasticity of demand tells us how much the quantity demanded decreases. It is important topic in economic. Market is always changing and if price for the product will change elasticity tells us how much other things will change. The relationship between price elasticity and total revenue is important. Based on analysis of elasticity management will determine the necessary changes on pricing policy for goods and services. To maximize company’s revenue the price for goods and services should be right. The key factor in establishing the right price is to use price elasticity analysis to predict marginal revenue. This kind of economic analysis uses a specific mathematical formula to describe the ideal theoretical relationship between elasticity and marginal revenue. Every company can use the price elasticity of demand for products to set correct pricing policies. Optimal pricing policy will maximize the profit of the company and allow the prices for the goods be exactly as market dictates. In order to establish the right price managers should look at different factors which could affect elasticity are in the following ways:

Factors affecting price elasticity of demand :

1. The number of close substitutes – the more close substitutes there are in the market, the more elastic is demand because consumers find it easy to switch. E.g. Air travel and train travel are weak substitutes for inter-continental flights but closer substitutes for journeys of around 200-400km e.g. between major cities in a large country.
2. The cost of switching between products – there may be costs involved in switching. In this case, demand tends to be inelastic. For example, mobile phone service providers may insist on a12 month contract which has the effect of locking-in some consumers once a choice has been made
3. The degree of necessity or whether the good is a luxury – necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand. An example of a necessity is rare-earth metals which are an essential raw material in the manufacture of solar cells, batteries. China produces 97% of total output of rare-earth metals – giving them monopoly power in this market
4. The proportion of a consumer's income allocated to spending on the good – products that take up a high % of income will have a more elastic demand
5. The time period allowed following a price change – demand is more price elastic, the longer that consumers have to respond to a price change. They have more time to search for cheaper substitutes and switch their spending.
6. Whether the good is subject to habitual consumption – consumers become less sensitive to the price of the good of they buy something out of habit (it has become the default choice).
7. Peak and off-peak demand - demand is price inelastic at peak times and more elastic at off-peak times – this is particularly the case for transport services.
8. The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change.

Why Elasticity Is Important ?

Marketers must have some knowledge about the elasticity of their products to set pricing strategies. If marketers know that the demand for their products is inelastic, then they can raise prices without fear of losing sales. On the other hand, if demand for their products is highly elastic, then raising prices could be a dangerous game.

The relationship between price elasticity and total revenue is an important metric for marketers to understand. Understanding whether the price of a product is elastic or inelastic is essential for a company to develop an effective marketing campaign and survive in the marketplace. Price elasticity is a tool that marketers can use against their competitors to increase their share of a market.

When demand is inelastic, a rise in price leads to rise in total revenue. For example, a 20% rise in price might cause demand to contract only by 5%. In this case, the PED (Price elasticity of demand will be -0.25.

When the price elasticity of demand is elastic, a fall in price will lead to rise in total revenue. For instance, a 10% fall in price might cause demand to expand by 20%. The PED in this case will be +2.5.

When price elasticity is perfectly inelastic, (when PED is zero) a given price change will result in the same revenue change. For instance, a 10% increase in price results in a 10% increase in total revenue. The information on the PED can be used by a business for price discrimination. A supplier can decide to charge different prices for the same product to different segments of the market, for example, peak or off peak rail travel tickets or prices by air travel operators.

* For non-durable goods, elasticity tends to be greater over a long-run than the short-run. For example, if the price of gasoline increases, consumers may continue to fuel their cars in the short-run, but may lower their demand for gas by switching to public transportation over a longer period to time. The demand for durable goods tends to less elastic, as it becomes necessary for consumers to replace them with time.

* Tax incidence decides who will pay the taxes associated with the product, the sellers or the buyer. If supply is more elastic than the demand, the consumer ends up paying more taxes. When demand is more elastic than supply, the seller has to absorb the entire tax burden. Government can use elasticity when establishing taxes for inelastic products. For example, cigarettes and alcohol. The demand for these products is inelastic, increase in taxes will generate significant increase in tax revenues.

Market failure occurs when the price mechanism fails to account for all of the costs and benefits necessary to provide and consume a good. The market will fail by not supplying the socially optimal amount of the good.

Prior to market failure, the supply and demand within the market do not produce quantities of the goods where the price reflects the marginal benefit of consumption. The imbalance causes allocative inefficiency, which is the over- or under-consumption of the good.

The structure of market systems contributes to market failure. In the real world, it is not possible for markets to be perfect due to inefficient producers, externalities, environmental concerns, and lack of public goods. An externality is an effect on a third party which is caused by the production or consumption of a good or service.

During market failures the government usually responds to varying degrees. Possible government responses include:

• legislation – enacting specific laws. For example, banning smoking in restaurants, or making high school attendance mandatory.
• direct provision of merit and public goods – governments control the supply of goods that have positive externalities. For example, by supplying high amounts of education, parks, or libraries.

• taxation – placing taxes on certain goods to discourage use and internalize external costs. For example, placing a ‘sin-tax’ on tobacco products, and subsequently increasing the cost of tobacco consumption.
• subsidies – reducing the price of a good based on the public benefit that is gained. For example, lowering college tuition because society benefits from more educated workers. Subsidies are most appropriate to encourage behavior that has positive externalities.
• tradable permits – permits that allow firms to produce a certain amount of something, commonly pollution. Firms can trade permits with other firms to increase or decrease what they can produce. This is the basis behind cap-and-trade, an attempt to reduce of pollution.
• extension of property rights – creates privatization for certain non-private goods like lakes, rivers, and beaches to create a market for pollution. Then, individuals get fined for polluting certain areas.
• advertising – encourages or discourages consumption.
• international cooperation among governments – governments work together on issues that affect the future of the environment.

Reasons for market failure include:

• Positive and negative externalities: an externality is an effect on a third party that is caused by the consumption or production of a good or service. A positive externality is a positive spillover that results from the consumption or production of a good or service. For example, although public education may only directly affect students and schools, an educated population may provide positive effects on society as a whole. A negative externality is a negative spillover effect on third parties. For example, secondhand smoke may negatively impact the health of people, even if they do not directly engage in smoking.
• Environmental concerns: effects on the environment as important considerations as well as sustainable development.
• Lack of public goods: public goods are goods where the total cost of production does not increase with the number of consumers. As an example of a public good, a lighthouse has a fixed cost of production that is the same, whether one ship or one hundred ships use its light. Public goods can be underproduced; there is little incentive, from a private standpoint, to provide a lighthouse because one can wait for someone else to provide it, and then use its light without incurring a cost. This problem – someone benefiting from resources or goods and services without paying for the cost of the benefit – is known as the free rider problem.
• Underproduction of merit goods: a merit good is a private good that society believes is under consumed, often with positive externalities. For example, education, healthcare, and sports centers are considered merit goods.
• Overprovision of demerit goods: a demerit good is a private good that society believes is over consumed, often with negative externalities. For example, cigarettes, alcohol, and prostitution are considered demerit goods.
• Abuse of monopoly power: imperfect markets restrict output in an attempt to maximize profit.

When a market fails, the government usually intervenes depending on the reason for the failure.