Question

With the aid of a diagram, discuss the concept of scarcity, opportunity cost and unemployment for a hypothetical economy producing cars and potatoes. 1.2 Define price elasticity of demand and use a diagram to illustrate the relationship between price elasticity of demand and total revenue.

Answer 1

Definitions

Economics — The study of how individuals and society make decisions about how to use scarce resources to satisfy unlimited material wants.

Scarcity — The condition that exists when there are not enough resources to satisfy all the wants of individuals or society.

we introduced the concept of elasticity and how to calculate it, but we didn’t explain why it is useful. Recall that elasticity measures responsiveness of one variable to changes in another variable. If you owned a coffee shop and wanted to increase your prices, this ‘responsiveness’ is something you need to consider. When you increase prices, you know quantity will fall, but by how much.Elasticities can be divided into three broad categories: elastic, inelastic, and unitary. An elastic demand is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price. Elasticities that are less than one indicate low responsiveness to price changes and correspond to inelastic demand. Unitary elasticities indicate proportional responsiveness of either demand or supply, as summarized in the following table:

If we were to calculate elasticity at every point on a demand curve, we could divide it into these elastic, unit elastic, and inelastic areas, as shown in Figure 4.2a. This means the impact of a price change will depend on where we are producing. Feel free to calculate the elasticity in any of the regions, you will find that it indeed fits the description.

Figure 4.2a

To demonstrate, we have calculated the elasticities at a point in each of the zones:

Point A = ΔQΔP⋅PQ=96.75⋅4.53=2ΔQΔP⋅PQ=96.75⋅4.53=2 = Elastic

Point B = ΔQΔP⋅PQ=96.75⋅35=0.8ΔQΔP⋅PQ=96.75⋅35=0.8 = Inelastic

Point C = ΔQΔP⋅PQ=96.75⋅3.3754.5=1ΔQΔP⋅PQ=96.75⋅3.3754.5=1 = Unit Elastic

In reality, the only point we need to find to determine which areas are elastic and inelastic is our point where elasticity is 1, or Point C. This isn’t as hard as it may seem. Since our formula is equal to the inverse of our slope multiplied by a point on the graph, it will only equal 1 when our point is equal to the slope of our graph. For a linear graph, this only occurs at the middle point, which is (4.5, 3.325) in this case.

So far, we have determined how to calculate elasticity at and between different points, but why is this knowledge useful?

Consider a coffee shop owner considering a price hike. The owner has two things to account for when deciding whether to raise the price, one that increases revenue and one that decreases it. Elasticity helps us determine which effect is greater. Referring back to our table:

1. When you increase price, you increase revenue on units sold (The Price Effect).
2. When you increase price, you sell fewer units (The Quantity Effect).

These two effects work against each-other. To determine which outweighs the other we can look at elasticity:

When our point is elastic our %changeinquantity>%changeinprice%changeinquantity>%changeinpricemeaning if we increase price, our quantity effect outweighs the price effect, causing a decrease in revenue.

When our point is inelastic our %changeinquantity<%changeinprice%changeinquantity<%changeinprice meaning if we increase price, our price effect outweighs the quantity effect, causing a increase in revenue. This information is summarized in Figure 4.2b:

Figure 4.2b

The first thing to note is that revenue is maximized at the point where elasticity is unit elastic. Why? If you are the coffee shop owner, you will notice that there are untapped opportunities when demand is elastic or inelastic.

If elastic: The quantity effect outweighs the price effect, meaning if we decrease prices, the revenue gained from the more units sold will outweigh the revenue lost from the decrease in price.

If inelastic: The price effect outweighs the quantity effect, meaning if we increase prices, the revenue gained from the higher price will outweigh the revenue lost from less units sold.

Relationship between the price elasticity of demand and total revenue

The relationship between price elasticity of demand and a firm’s total revenue is an important one since generating revenue is a necessary part of running a successful business. Total revenue is the total amount of money a company makes by selling goods and services. Price elasticity is the economic term which explains that if the price of a product goes up, consumers buy less of it. If the price goes down, consumers buy more. 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 (Woodruff, 2019).

Impacts of various forms of elasticities on Business decisions

Businesses must have knowledge about the elasticity of their products to set pricing strategies. If business managers/owners 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 detrimental to the company. There are basically three main types prices elasticity of demand: elastic demand, inelastic demand and unit elastic demand.

Elastic demand happens when there is a decrease in price that will increase total revenue. Even though in such a scenario it is assumed that a lesser price per unit will generate a loss, because of the law of demand enough additional units will be sold to make up for the decrease in price of the product. Additionally, when price a total revenue move in opposite directions and demand’s percentage change is greater than 1 demand is elastic (McConnel, Brue & Flynn, 2018, pg. 125). Elastic demand can be further categorized into perfectly elastic and relatively elastic. When a small change in price of a product causes a major change in its demand resulting in fall in demand to be zero, it is said to be perfectly elastic demand. Similarly, relatively elastic demand refers to the demand when the proportionate change produced in demand is greater than the proportionate change in price of a product (Méndez-Carbajo & Asarta, 2017).

Inelasticity of demand happens when there is a price decrease that reduces total revenue. In this case the increase in sales will not fully offset the decline in revenue per unit, hence total revenue will decline. Business will know when demand is inelastic since a price increase will increase total revenue and will move in the same direction and will be less than 1 (McConnel, Brue & Flynn, 2018, pg. 126). Like elastic demand, inelastic demand is also broken down into perfectly inelastic and relatively inelastic. A perfectly inelastic demand is one when there is no change produced in the demand of a product with change in its price. Similarly, relatively inelastic demand is one when the percentage change produced in demand is less than the percentage change in the price of a product (Méndez-Carbajo & Asarta, 2017).

In unit elasticity changes in price of a product or service do not affect total revenue. The loss in revenue from a lower unit price is exactly offset by the gain in revenue from the accompanying revenue in sales. Conversely, the gain in revenue from a higher unit price is exactly offset by the revenue loss associated with the accompanying decline in the amount demanded (McConnel, Brue & Flynn, 2018,

shows the demand curve for products when demand is elastic, inelastic and unit elastic.

To illustrate elasticity, let us look at an example that shows the demand for cooking/table salt. Table 1 shows the Demand schedule for table salt

Price $		Quantity (lbs.)
5		150
8		100

To compute the elasticity of demand for table salt it is recommended to use the midpoint formula. The formula is Ed  =

Change in quantity Sum of quantities  /2

÷

change in priceSum of prices  /2

Where p1= 5, P2= 8, Q1= 150, Q2= 100

Ed =

Q2-Q1Q1+Q2  /2

÷

P2-P1(P1+P2 )/2

Ed=

100-150100+150/2

  ÷

8-5(8+5)/2

=

-50125

÷

36.5

=

-0.40.462

= -0.866

Conclusion:

The concept of elasticity of demand is of great importancefor determining prices of various factors of production. In other words, if the demand of a factor is inelastic, its price will be high and if it is elastic, its price will be low. It is related to total revenue which can benefit business once they have knowledge of it and can capitalize on how to treat their elastic and inelastic products in order to minimize their profits.

The effects of price increase and decrease at different points are summarized