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ECONOMICS

ESSAY
2003
(a)

Explain the concepts of price elasticity of demand and income elasticity of demand, indicating why
elasticites are different for different products. [12]

(b)

Discuss how a supplier of a product that is currently fashionable might use both these concepts in
making pricing and output decisions. [13]

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Part a
Elasticity is a very important concept in economics. The various concepts can enable us to gain better insights to
not only how events, economic and non-economic, can affect markets, but the extent to which these markets are
impacted. The second part of this essay then aims to discuss the usefulness of how price elasticity of demand
(PED) and income elasticity of demand (YED) can help in explaining the usefulness in deciding pricing and
output decisions for a good that is currently fashionable. However, before I examine the issue, I shall first explain
the two above mentioned concepts.
PED refers to the degree of responsiveness of quantity demanded of a good to a given change in the price of the
good itself, ceteris paribus. It can be calculated by taking the percentage change of quantity demanded divided
by the percentage change in the price of the good. Due to the Law of Demand, where price and quantity are
inversely related, the value of PED is always negative, hence, for simplicity we always ignore the negative value
of PED.
PED has a value ranging from 0 to -, but as mentioned earlier we ignore the negative value for convenience. If
a good had a price of $5 which rose to $6 and the quantity demanded of the good decreases from 100 units to
90 units. The percentage increase of price would be 20% and the percentage decrease in quantity demanded is
10%. Therefore, the PED value of the good is and demand is said to be price inelastic, as the quantity
demanded of the good decreases less than proportionate to the increase in price, or vice versa, where goods
with a PED value more than one is said to be price elastic in demand. Figures 1 and 2 demonstrate the concept
of price inelastic demand and price inelastic demand respectively.

Figure 1: Market for a good with a

Price inelastic demand

Factors that affect the price elasticity of demand for goods include, but are not exclusive to the degree of
necessity, the availability of close substitutes etc. The lesser the degree of necessity of a good, the more price
elastic is the demand for the good. This is because consumers can easily reduce the quantity consumed of such
a good. If price rises, it readily discourage consumers from purchasing the good, hence the quantity demanded
of the good would fall more than proportionately to the rise in price. The greater the availability of close
substitutes, the more price elastic the demand for a good-when there are other close substitutes available in the
market, consumers can easily switch to buying these substitutes when the price of the good rises, vice versa.

Next, YED refers to the degree of responsiveness of quantity demanded of a good in response to a given change
in the income of consumers, ceteris paribus. YED can be calculated by measuring the percentage change in the
quantity demanded of the good divided by the percentage change in the income of consumers. YED has a range
of values from - to . For inferior goods, demand falls as income rises, which can be seen from Figure 3;
hence, YED<0. For normal goods YED>0 because demand rises as income rises. Within normal goods,
necessities have YED<1, seen in Figure 4, meaning that an increase in income leads to a less than proportionate
increase in demand, while for luxury goods, seen in Figure 5, YED>1 as an increases in income leads to a more
than proportionate increase in demand.
An inferior good is a good where the quantity demanded of the good falls as income rises. This is because as
income rises, consumers are more able to afford better quality goods compared to goods of an inferior quality
and will switch to buying normal goods. For normal goods, the main determinant of the value of YED is the
degree of necessity. The greater the degree of necessity, the lower the value of YED. Once consumers have
fulfilled their basic necessities, they would be less likely to consume more necessities as they would rather spend
their income on luxury goods in which consumers would derive a greater level of satisfaction from the
consumption of luxury goods.

Part b
Now, after explaining the concepts of PED and YED which help us to understand the extent to which quantity
demanded of a good can be affected by the pricing of goods as well as the income of consumers, I will now show
how PED and YED are both useful in helping a firm make pricing and output decisions for a good that is currently
fashionable.
A product that is currently fashionable would experience an increased demand for the good as change in tastes
and preferences cause consumers to be more willing to purchase the product in discussion. This results in a
parallel, upward shift of the demand curve, causing both quantity demanded and price to rise, as represented by
Figure 6 below.

As demand for the good increases at the original price level, Po, there is a shortage of QoQo. This shortage will
cause an upward pressure on the market price for the good. As price rises, quantity demanded for the good will
start to fall as consumers become less willing and able to buy the good. At the same time, quantity supplied will
start to rise as firms become more willing and able to supply the good at a higher price. As a result, the shortage
becomes smaller. However, the market adjustment process will continue to exert an upward pressure on price,
until the shortage is eliminated and the new equilibrium, E1, is reached where quantity supplied equals the
quantity demanded once again.
Since the good is currently fashionable, consumers are likely willing to pay a higher price for the good given its
popularity, hence the quantity demanded of the good would fall less than proportionately to the increase in price
of the good. In other words, it is of a high degree of necessity to the average consumer-with a higher degree of
necessity, the lower the value of PED and hence the good is price inelastic in demand. During this period of time
when the good is fashionable, firms aiming to maximise profits should raise the price of the good to maximise
revenue. Since the product is price inelastic in demand, a rise in the price of the good would lead to a less than
proportionate fall in the quantity demanded of the good, hence leading to an increase in total revenue earned-this
can be demonstrated through Figure 7. Before price is raised, the total revenue represented by Area (A+B) and
after the price is raised, total revenue would be represented by Area (A+C) and since Area C>Area A, total
revenue would increase.

Figure 7: Market for a good with highly inelastic demand


The above argument assumes there are no close substitutes to the product. However, if one were to consider the
notion that the currently fashionable product would have many variations-many other close substitutes, since
these substitutes offer similar, but not exact qualities, consumers are then able to readily switch from buying one

variation of the product to another. An example of such a product could be bags that look similar and its design is
currently fashionable, but they are not exactly the same in terms of material and price. This would make the
demand for the currently fashionable product highly price elastic. Considering this, one might then arrive at a less
conclusive outcome. To illustrate, Ill reproduce Figure 7 with a highly price elastic demand.

Figure 6: Market for a good with highly price elastic demand


In Figure 6, a rise in the price of the good would result in a more than proportionate fall in the quantity demanded
of the good, and revenue generated from the increase in price would lead to a fall in total revenue. Thus, to
generate a higher revenue from a good of price elastic demand, the firm should lower its price if it can, which
leads to a more than proportionate increase in quantity demanded and total revenue would increase.
Since the question did not set the context of the current economic situation, it is difficult to assess whether the
good in question is an inferior good or a normal good. This is because during periods of economic growth, when
household incomes generally increase, goods with high YED values would experience greater increases in
demand than goods with lower YED values. The increase in total revenue in the former would be greater than the
latter. Conversely, in an economic recession, falling incomes means that the demand for normal goods would fall
and the demand for inferior goods would rise. Therefore, it cannot be certain whether the good is an inferior good
or a normal good, since no economic context is set in the question.
However, in both scenarios, the firm producing a currently fashionable product should consider increasing
production and if their capacity does not allow for the increased output, they should consider increasing
investment in new capacity while the product is still fashionable. Assuming that the supply curve does not shift,
quantity demanded for the product will surely increase and therefore, total revenue is likely to increase only if the
firm is able to use YED to predict the estimated increase in the demand for its product to cope with the demand.
Despite its usefulness in helping the firm in pricing and output decisions, the use of elasticity concepts is hinged
on the ceteris paribus assumption. In theory, when a firm decides to alter the pricing of a good, it can use PED to
estimate the amount of change in quantity demanded of the good and hence adjust its production. However,
such estimates depend crucially on the assumption of ceteris paribus, where all variables remain unchanged. In
reality, an adjustment in pricing could trigger a response from a rival firm that may respond with price or non-price
actions. Therefore, predictions of revenue changes using elasticity concepts become inaccurate and cannot be
used as a precise tool. It is however, useful in providing a guide in terms of output and pricing decisions.