The law of demand for normal goods implies that as the price of good changes, all other factors unchanging, and the quantity for that good demanded change inversely to the price. Therefore as prices increases, demand falls and vice versa. The price elasticity of demand therefore measures this responsiveness of change to price. Hence, the price elasticity of demand can be defined as the responsiveness of demand of a product due to the change in its price. This elasticity can either be elastic, inelastic or linear depending on the degree of change in demand relative to the change in price.
The price elasticity is therefore calculated using the percentage changes. The general formula of calculating the price elasticity of demand is given by percentage change in quantity denuded divided by the percentage change in price.
The price elasticity however does not equal to the slope of the demand curve. The slope of the demand curve gives ratio of the change in price over the change in quantity. The slope therefore gives the actual change in the inverse hence cannot be used to measured price elasticity if demand. Elasticity is calculated using the percentage changes in price and quantity and can therefore not derive from the slope of the demand curve.
The income elasticity of demand of good measures the change in demand of a good due to changes in the income levels all other factors constant. On the other hand the elasticity of demand measures the change in demand of a good as a result of a change in the price of other goods. The cross elasticity is calculated as percentage change in in quantity demanded for the first good over the change in price of the second good while the income elasticity is the percentage change in quantity demanded over the percentage change in income. All three elasticities measure the change in demand resulting in any other changes of the factors that affect the demand for the good.
These products Ice Cream, Peter’s Chocolate Ice Cream, Chocolate Ice Cream, Frozen Desserts, and Desserts are essentially the same products and fall under the same categories as desserts. Their ranking will therefore be in relation to the fact that they can be substitutes. Desserts will therefore rank as the most elastic products since it has no close substitutes and it is in general the category of all the products. The second will be frozen desserts. Ice cream will take the third position since it is a category under frozen desserts. Ice creams can be further put in different flavors such as chocolate. In this case, then peters chocolate ice cream that falls under chocolate ice cream will therefore take the least elastic after the chocolate ice cream category.
Application and Awareness
The price elasticity of demand is not necessarily reported using the sign. This is because the law of demand implies a negative relationship between the price and the demand of a good. Therefore the price elasticity of demand will always be a negative hence it is not necessary to report the sign of the elasticity.
Income elasticity of demand is given by
The income elasticity can either be negative or positive depending on the type of good. This is because consumers to do not react in the same manner while purchasing different goods if their income level changes. Therefore to differentiate the type of good on which the income elasticity related it is prudent to add the sign of the elasticity.
The income elasticity can be used to classify goods as either inferior or normal goods and further as a luxury or a necessity. The income elasticity is positive for normal goods implying that the demand for goods will increase as the income increases. In this example therefore, rice and cars can be considered as normal goods.
The income elasticity of inferior goods is always negative. This implies that consumer demand less of a good when their income increases. In this example therefore, the second hand books can be considered as inferior goods as the income elasticity is negative.
Normal goods can further be classifies as a luxury good or a necessity depending on the absolute value of the income elasticity. If the income elasticity is greater than unity then the good can be classified as a luxury while the good is a necessity if the income elasticity is less than unity. Therefore the car can be further classified as a luxury good. The rice is classified as a necessity since the income elasticity is at 0.4, less than unity.
Cross elasticity is given by
The cross elasticity of demand for two goods define the relationship that exists between the two goods. This could either be substitutes or compliments. The sign of the cross elasticity of demand will either be positive or negative depending on the relationship of the two goods. Therefore to determine if the goods are substitutes or compliments it is important to report the sign of the elasticity.
In this example the cross elasticity of demand of cars with respect to the price of petrol is negative.
The sign of the cross elasticity shows if the goods are substitutes or compliments. If the two goods are complimentary goods then the sign of their cross elasticity will be negative but if they are substitutes then the sign of the cross elasticity will be positive. Therefore given that the cross elasticity of demand for cars with respect to petrol price is negative, and then cars and petrol are complimentary goods.
Learning Life Lessons
Elasticity and total revenue
The price elasticity of a good can either be elastic, inelastic or unit elastic.
If the price elasticity of demand is elastic, it implies that the demand changes with a high proportionate that the change in price. If the price is reduced by a given percentage, then the demand will inverse by more than that percentage change in price. Therefore if a form were to reduce the price of a commodity, with elastic demand, then the revenues will increase instead since demand will be higher than the proportionate change in price.
If the price elasticity of demand of a good is unitary elastic, then it implies that the change in demand will be in the same proportion as the change in price. Therefore if a firm were to reduce the price of a commodity then the demand for that good will increases with the same proportion. Since the demanded quantity and the price changes in the same proportion, then the total revenue for the firm will remain the same over the range of unit elastic demand.
If the demand of a good is inelastic, then a change in price for that good will result in a less proportionate change in the quantity of that good demanded. Therefore if the price was to be reduced by a given percentage, then the demand for that good will increase by a less percentage than the percentage change in price. Since the quantity demanded will be increased by a less margin, then the firm will have less total revenues as a result of the price decrease.
Conflicts of interests
The disparities of these changes as a result of the price changes could result in conflicts of interest between the sales manager and the CEO. The ultimate goal of the sales manager is to increase the sales volumes of the company’s products while the CEO cares more for the total revenues values than anything else. The sales manager could increase the sales volume by reducing the price of the product. However the elasticity of the products will determine the impact of the change on revenues. There exists a conflict of interest with this decision of the sales manager if the good is elastic since revenues will be falling.
The impact of price elasticity on revenues could also have an impact on the agency relationship between sales reps and the shareholders. The sales rep all has the goal of increasing the sales volume of the product while the shareholders concerns are centralized on the profitability of the firm. There exists a conflict of interest between these two groups for elastic goods when the sales reps reduce the price to increase the sales volumes while in actual fact the profitability of the firm is going low.