Question

Using examples of goods or services you are familiar with, explain how does the knowledge of price elasticities helps these two entities to make pricing decisions.

(a) A very popular fried koay teow seller in Penang. (400 words)

(b) A fashion boutique. (400 words)

Answer 1

Answer

The price elasticity of demand shows the responsiveness of the quantity demanded for a good for the change in its price.It is measured in percentage term, i.e percentage change in quantity demanded for a good for the percentage change in its price.

If the consumer consumes good X , whose price is P_X , then the price elasticity of good X(_X) is as follows,

_X = Percentage change in X / Percentage change in P_X

Or, _X = (X / X) / (P_X /P_X) , where '' stands for change.

The price elasticity of demand for a good plays a very important role in business when it comes to take decision on price of a good.

The price elasticity of demand for a good can be '0' , '1', '>1', '<1', or '∞'

If the quantity demanded for a good doesn't change for the change in its price, then _X = 0.

If the quantity demanded for a good changes at the same rate of the change in its price, then _X = 1.

If the quantity demanded for a good changes greater than the change in its price, then _X >1.

If the quantity demanded for a good changes less than the change in its price, then _X <1.

If the quantity demanded for a good is infinite for the change in its price, then _X = ∞

When the price elasticity of demand is greater than '1', then it called elastic demand. When the price elasticity of demand is less than '1', then it called inelastic demand. When the price elasticity of demand for a good is '0', then it is called perfectly inelastic demand.

In case of normal and necessary goods, the price elasticity of demand varies between '0' to '1'. In case of normal and luxury goods, the the price elasticity of demand is greater than '1'

Now, how a firm will take decisions on price, it depends on the nature of the good. For a very necessary goods, like food items, medicine, water, etc., either the demand won't change or if changes, it will change in negligible amount for a change in price. For a luxury items, the responsiveness of the change in quantity demanded is large for the change in the price of a good.For a small change in price of a good, the quantity demand may change at a huge amount. Again if the goods have close substitutes, then a small change in the price of a good,may change the quantity demanded of the good at a large amount because of the availability of its substitute/substitutes.

So for a very necessary item that has no close substitutes, if the firm increases the price if the item, it won't affect the firm's revenue and profit. For a luxury good, if the firm increases the price of the good, it will have a great impact on the quantity demanded for the good, which may decline the firm's revenue and profit.

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(a) A very popular fried koay teow seller in Penang - There are many sellers that sells fried koay teow in Penang. So it's a competitive market,yet all the sellers have their own special fried koay teow , which is different than other seller's fried koay teow. This is the reason why there is a very popular fried koay teow seller in Penang. Basically the market is a monopolistic competitive market. The elasticity of demand for food item is basically inelastic , i.e., the responsiveness of quantity demanded for a food item is negligible for the change in its price. As the seller of fried koay teow in Penang is very popular , so the demand for its fried koay teow is much larger than any other fried koay teow seller in Penang. In the competitive market, the consumers are very aware of the market and in monopolistic competitive market, the people always look for the item which is qualitatively different than other items. There are various items with their own brand names, and people choose the best one if it is affordable. In this case of fried koay teow, if the very popular seller in Penang increases the price of its fried koay teow, it won't hamper the demand for its fried koay teow , because the seller is popular for its own special fried koay teow. If the seller in the question increases the price of its fried koay teow in small amount, it will increase its revenue (price of fried koay teow * quantity of fried koay teow) . As the revenue rises with the rise in price, the profit ( total revenue - total cost ) will also rise.So the profit maximizing seller will always like to increase the price in smaller amount that will raise its profit.

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(b) A fashion boutique - The fashion boutique industry is very competitive industry though all the boutiques are different in their own brand names. They all produce same things(clothes) but always try to make their products different in design and in quality from other boutiques product. A little price change can change the quantity demand a lot. So the fashion boutiques try to deliver the qualitative products at a price that won't hamper the quantity demanded for their products.The higher the competition, higher would also be the price competition in the market. he price elasticity of demand of every boutique is highly elastic. So the fashion boutiques are cautious enough in changing the price. Sometimes they even lower the price to sell their products.The price elasticity of demand of every boutique is highly elastic.

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